Purchasing Power Parity (PPP)

Purchasing Power Parity (PPP) allows us to compare economies more effectively than nominal purchasing power. It enables us to assume that all people are using the same currency and that prices all over the world are the same, helping us measure the affluence of each country in a comparable way. This provides a clearer picture of the global economy.

Why Do We Use Purchasing Power Parity?

For example, let’s consider the USA and Mexico. According to IMF standings, American GDP per capita in 2010 was $44,155.00 while in Mexico it was $8,051.92.

At this point one might assume that on average Mexicans are five times poorer than Americans. But this is incorrect. By using PPP, the numbers become quite different. American GDP per capita by PPP was $47,123, and Mexican GDP per capita was $14,266. This means that Mexicans are only three times poorer, not five times as with nominal GDP.

The main reason for using PPP is the ability to compare economies that use different currencies.

Nominal values are ineffective for comparing affluence among countries. As an example, imagine that you are buying potatoes in the US and Mexico, perhaps for a restaurant. You pay $2 per pound in the US and you are willing to spend up to $1000. Thus, your budget allows you to buy 500 pounds of potatoes. You might think that you can buy the same amount in Mexico, but the price in Mexico is lower: for $1000 you can buy one ton (2,000 pounds) of potatoes. So to buy 500 pounds in Mexico you will have to spend just $250. The difference in prices makes Mexicans wealthier than at first glance.

There is another problem. All prices in Mexico are not four times lower than in the US. The difference in price depends on the good.

Another example of the inaccuracies of only using nominal values to compare economies can be seen in exchange rates. Today the exchange rate for 1 dollar may be 12 pesos. However, if at some point 24 pesos are traded for 1 dollar, have Mexicans become twice as poor? Of course not. Exchange rates result from international trade and financial markets. If incomes and prices measured in pesos stay the same, Mexicans will be no worse off assuming that imported goods are not essential to an individual's quality of life.

Purchasing Power Party was established to deal with these problems. PPP is arguably better for comparing general differences in living standards among nations because PPP takes into account the relative cost of living and inflation rates. Using exchange rates alone may distort the real differences in income. In addition, measures of savings, such as national wealth, may be distorted.

PPP Calculation

PPP is calculated by measuring the cost of a common basket of goods. However, finding an optimal basket that catches all price differences is complicated by several problems. Countries do not simply differ in a uniform price level. The difference in food prices may be greater than the difference in housing prices, for instance. People in different countries typically consume different baskets of goods, making it necessary to use a price index to compare costs. This, in turn, is problematic because purchasing patterns and even the goods available to purchase differ across countries, making it necessary to adjust for differences in the quality of goods and services as well.

Two Types of PPP

We can distinguish two types of PPP. The first is Absolute PPP (which is more common), and the second is Relative PPP.

Absolute PPP assumes that a basket of goods should cost the same in the US and Mexico once the exchange rate is taken into account. Unfortunately, this doesn't work. It is almost impossible to construct a basket of goods that will cost the same (or nearly the same) in two countries after adjusting for exchange rates.

Relative PPP describes differences in the rates of inflation between two countries. Suppose the rate of inflation in Mexico is higher than that in the US, causing the price of a basket of goods in Mexico to rise. Purchasing Power Parity requires the basket to be the same price in each country, so this implies that the Mexican peso must depreciate against the US dollar. The percentage change in the value of the currency should then equal the difference in the inflation rates between the two countries. Thus over the long term, only changes in prices are likely to influence currency exchange rates. However, note that short term currency moves are not explainable this way, and other measures (such as quantitative and technical analysis) must be used to gain better insight.

The Big Mac Index

Because many economists do not consider Purchasing Power Parity accurate enough, other types of measures have been developed. One example that uses the "law of one price," which underlies Purchasing Power Parity, is the Big Mac Index popularized by The Economist. This measure looks at the price of a Big Mac hamburger in McDonald's restaurants in different countries.

The Big Mac Index is very useful because it is based on a well-known good whose final price is easily tracked in many countries and includes input costs from a wide range of sectors in the local economy, such as agricultural commodities (beef, bread, lettuce, cheese), labor (both blue and white collar), advertising, rent and real estate, transportation, etc. However, in some emerging economies, western fast food represents an expensive niche product, well above the price of traditional staples. The Big Mac in these countries is not a "cheap" mainstream meal as it is in the west, but a luxury import for the middle class and foreigners.

Purchasing Power Parity and Gold

What is the link between purchasing power parity and gold? At first glance, there is no relationship at all, as purchasing power parity merely allows us to make more reliable comparisons about the standard of living in different countries.

However, purchasing power parity is actually something more than a statistical tool. It is also a theory of the determination of the exchange rates. According to this approach, the exchange rate between two currencies should be equal to the ratio of the currencies’ purchasing power. Hence, two currencies are traded at an equilibrium exchange rate when their domestic purchasing powers at that rate of exchange are equivalent.

Clearly, domestic purchasing power is determined by the rate of inflation. Therefore, the implication is that the main driver of changes in the exchange rate in the long run is the difference in the inflation rates in the two countries. In turn, inflation is determined by the changes in money supply and the monetary policies conducted by central banks.

How is, then, gold linked to purchasing power parity? Well, gold behaves like a currency, in a sense, so it is sensitive to changes in exchange rates between national fiat currencies and the divergence in monetary policies of the major central banks. In the past, the dovish BoJ’s moves strengthened the U.S. dollar and thus were bearish for the price of gold (the yellow metal is negatively correlated with the greenback).

Hence, investors can use PPP figures to find potentially overvalued or undervalued currencies, or to predict whether the U.S. dollar – and so the price of gold – will appreciate or depreciate.

We encourage you to learn more about the precious metals market – not only about the link between purchasing power parity and gold, but also how to successfully use gold as an investment and how to profitably trade it. A great way to start is to sign up for our gold newsletter today. It's free and if you don't like it, you can easily unsubscribe.