What Are the Different Methods for Determining PPP?

Malcolm Tatum

PPP, or purchasing power parity, is a term used to describe the steps that must be taken to achieve a balance between the purchasing power of the currency issued by one nation with the purchasing power of the currency issued by a different nation. Determining PPP typically calls for considering factors such as the rate of exchange that applies to the two currencies involved, then taking into account the cost of a specific good using the currency of each nation. With this information in hand, it is possible to identify whether the current level of parity between the two nations is considered acceptable, or if some sort of adaptation is necessary in order to achieve a more equitable balance.

Businesswoman talking on a mobile phone
Businesswoman talking on a mobile phone

One of the easiest ways to understand how PPP is determined is to consider the price of a new suit of clothing of the same brand and design, with that suit offered for sale in two different nations. In order to achieve price parity, it is important to consider the rate of exchange between the currencies issued by each of those nations. For example, if the suit is offered for sale in both the United States and the United Kingdom and the current rate of exchange between the US dollar and the British pound is one dollar for 1.5 pounds, this means that if the suit costs $500 US dollars (USD) in the United States, it would have to cost 750 British pounds in order for the two prices to be considered equal or on par with each other.

Since the rate of exchange between currencies can change quickly, taking the time to determine the current PPP can be very important to making purchases. For example, if a US-based consumer found that this same suit was being sold in the UK for 600 British pounds, this would represent a substantial savings over buying that same item in the US where the price was $500 USD. Assuming that the shipping costs were kept to a minimum, the US based consumer would benefit from ordering the suit from a UK supplier rather than buying it locally. Should the rate of exchange shift and the UK price for the suit were to move to 800 British pounds, then the parity would shift in a direction that would make purchasing the suit from a domestic supplier more cost-effective for that US-based customer.

An approach that tends to focus mainly on the current rate of exchange is known as absolute PPP. A slightly different approach that is known as relative PPP also takes into account other factors that may influence the benefits of purchasing international rather than domestic goods that are similar. With relative PPP, factors such as the rate of inflation that applies in each nation will be part of the evaluation of the retail prices for the goods under consideration. In addition, factors such as trade regulations between the two nations may have to be taken into account before determining if buying a good from an international location is inherently more cost-effective than purchasing that same good domestically.

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