PPP

Purchasing power parity (PPP) is a method of calculating the correct/real value of a currency which may be different from the market exchange rate of the currency. Using this method economies may be studied comparatively in a common currency. This is a very popular method handy for the IMF and WB (introduced by them in 1990) in studying the living standards of people in different economies. The PPP gives a different exchange rate for a currency which may be made the basis for measuring the national income of the economies. It is on this basis that the value of gross national product (GNP) of India becomes the fourth largest in the world (after the US, Japan, and China) though on the basis of market exchange rate of rupee, it stands at the thirteenth rank.

The concept of the PPP was developed by the great European conservative economist, Gustav Cassel (1866–1944), belonging to Sweden. This concept works on the assumption that markets work on the law of one price, i.e., identical goods and services (in quantity as well as quality) must have the same price in different markets when measured in a common currency. If this is not the case it means that the purchasing power of the two currencies is different.

Let us look at an example. Suppose that sugar is selling $1 in US and Rs. 20 in India a kilo then the PPP-based exchange rate of rupee will be $1 = Rs.

20. This is the way how The Economist of London has prepared its ‘Big Mac Index’ (comparing the Mc Donald’s Big Mac burger prices in different economies).

In theory, the value of currencies in terms of their market exchange rate should converge with their value in terms of the PPP in the long run. But that might not happen due to many factors like the fluctuations in inflation; level of money supply; follow-up to the exchange rate regimes (fixed, floating, etc.), and other.

For the calculation of the PPP, a comparable basket of goods and services

is selected (a very difficult task) of the identical qualities and quantities. The other difficulty in computing PPP arises out of the flaw in the ‘one price theory’

i.e., due to transportation cost, local taxes, level of production, etc. The prices of goods and services cannot be the same in different markets (This is correct in theory only, not possible in practice.)