Purchasing Power Parity: Significance & Problems|UPSC Notes

Purchasing power parity is an economic theory that compares the currency of different countries based on their purchasing power. In other words, it looks at what amount of money buys something in different countries. This helps to understand the real value of money across the world. Many economists use purchasing power parity to study the standards of living and economic productivity across nations. This gives a more realistic comparison than what can be done with the conventional use of exchange rates, which are generally faced by several market factors.

• Purchasing power parity measures the power of different currencies, over different countries.
• The theory, in general, uses a simple comparison of expenses of goods and services between two nations
• Researchers, as economists, use the concept of PPP in studying living standards across countries
• A Purchasing Power Calculator helps to compare currencies with ease.

GS Paper	GS Paper I, GS Paper III
Topics for UPSC Prelims	Basic Concepts of Economics, Exchange Rate Mechanisms, Inflation and its Impact on Economy
Topics for UPSC Mains	Purchasing Power Parity: Concept and Significance, Exchange Rate Policies and India’s Foreign Trade, Role of PPP in International Comparison, Comparison of PPP vs Market Exchange Rate

What is Purchasing Power Parity?

The law of one price is the parent of purchasing power parity. It simply states that a homogeneous good must have one single price in an efficient market, no matter in which location it is sold. The adjustment for cost-of-living differences may make purchasing power parity a more realistic comparison of economies of various countries.

In reality, however, prices diverge because of transport costs, tariffs, and taxes, among other influences. As a result, there are deviations from this absolute PPP, which is the theory that goods should exhibit the same prices for any country when expressed in a common currency. These deviations notwithstanding, PPP remains one of the most conventional ways to determine the genuine value of currencies around the world.

Formula for Purchasing Power Parity

The math behind purchasing power parity is quite straightforward. It takes the price of a particular basket of goods in one country and divides that by the price of the same basket in another country. That yields the purchasing power parity exchange rate, which in turn gets applied to the adjustment of the GDP and other economic measures.

For instance:

PPP exchange rate = Cost of Basket in Country B / Cost of Basket in Country A

This simple formula stands tall in helping economists find and compare living standards between countries.

Significance of Purchasing Power Parity

Purchasing power parity holds significance in the economics of the world. PPP makes it possible to compare real productivity in economics of the globe; it provides a unique insight into the diverse levels of richness among nations. Given below are some reasons why it’s considered significant:

Comparison of Actual Economic Productivity

Purchasing power parity provides a more accurate way to compare economic well-being between countries. It adjusts for differences in price levels, offering a clearer picture of actual purchasing power that helps economists and policymakers make informed comparisons of living standards across different countries.

Adjustments to GDP

The PPP allows for the better calibration of GDP figures. It reflects the true income levels for countries. PPP takes into account the different in cost of living, hence, making the comparison of GDP more meaningful than if market exchange rates were being used, particularly for developing countries since market exchange rates often fail to be indicative of the true, domestic purchasing power of their currencies.

Global Price Comparisons

The PPP helps compare global price levels and inflation across different countries. It will give a fair idea of whether any currency is overvalued or undervalued by comparing prices of precisely similar goods and services in two different countries, a fact very useful for investors and businesses in international trade.

Policy Making

The government applies PPP to shed light on an insightful decision about economic policies, especially on the question of trade, exchange rates, and the strategies for development. If the policymakers comprehensively grasp the real purchasing power of their currency in relation to others, then they are able to devise a system of improving economic performance and competitiveness.

International Business and Investment

The PPP is also helpful in the measurement of real cost and benefit for businesses operating and investing across many countries. Additionally, it is also more realistic concerning giving a country-wise picture of the value of profit, investment, and cost, which forms the basis of strategic business decisions.

Purchasing Power Parity in India

Purchasing power parity is interesting in India. Since India is a developing country with a living cost lower than those of developed countries, the real value of the rupee is actually very much higher than that within the market rate. For example, if a dollar might convert to 80 rupees in the market, the purchasing power parity calculator may show that it is worth no more than 40 rupees in India due to the lower prices of goods and services.

Purchasing power parity in India is a big feature for international businesses and investors. It would serve to rightly perceive the Indian economy, as it controls for price levels, which are mostly lower than those of Western economies.

Problems with Purchasing Power Parity

While generally a useful tool, there are many problems with purchasing power parity. Despite these issues, PPP is still used by economists because of its usefulness in reflecting long-term currency movement and underlying economic stability. The following are some key issues with it: 

Price Differences

International prices of individual goods and services vary widely. These variations reflect differences in local production, availability, and demand for particular products. PPP needs comparable products, but quality and variety vary. Thus, even when different goods may be put to similar uses, direct comparison is difficult.

Non-tradable Goods

Most services, like health or education, are non-tradable, which means they cannot be bought across borders. These services may also be highly variable both in quality and cost from nation to nation. For these reasons, PPP cannot capture these variations, making it a less reliable tool for comparative analysis of such sectors. This creates problems when trying to work out an accurate exchange rate.

Changes in Exchange Rates

Market rates of exchange can be quite volatile and very often influenced by considerations of a short-term nature. While PPP works even better for comparisons over a longer period, it too cannot capture these kinds of rapid changes. In many instances, exchange rates influenced by political events, inflation, and speculation. Such fluctuations make it difficult to maintain exacting comparisons.

Transportation and Trade Barriers

Expenditures on transportation, duties, as well as other numerous taxes increase prices. This is only partly factored into PPP since such factors differ from nation to nation. This, therefore, would distort and bias the price comparison of merchandise, especially if the goods are to be moved over the border. Furthermore, limits to trade further complicate and still deplete the precision of PPP.

Government Policies

The Government influences prices through the imposition of taxes, subsidies, and regulations, which might give a different price level for goods and services. PPP cannot capture these policy changes that take place in prices. As a result, cross-country comparisons might not capture the real purchasing power of an individual.

Absolute Purchasing Power Parity

Absolute purchasing power parity essentially is a theoretical concept describing. As it describes the same goods must have the same costs across countries if measured in a common currency. It works only in the absence of impediments towards free flow, like transportation costs and trade barriers, apart from local taxes. Thus, absolute purchasing power parity could well be different from what one practically observes in reality.

In the case of India, while purchasing power parity in India would suggest a higher value of the rupee, due to such anomalies, it does not completely align with the market exchange rate. Yet, despite such discrepancies in value, purchasing power parity remains one of the most essential tools for benchmarking economic efficiency across economies.

Conclusion

Purchasing power parity is an important concept in economics. It allows a more accurate comparison of living standards and economic productivity across nations. Although the concept has its limitations, like differences in local prices and government policies. It does a much better job of showing what currencies are really worth compared to traditional exchange rates. In countries like India, where the purchasing power parity calculator conveys the realistic value of the rupee. It gives useful insights not only to businesses but also to investors and policymakers.

Purchasing Power Parity UPSC Notes

1. Purchasing Power Parity compares the relative value of currencies by assessing their purchasing power for a standard basket of goods. 2. PPP helps in understanding the cost of living differences between countries and provides a more accurate measure of economic productivity. 3. It is commonly used to compare Gross Domestic Product (GDP) across countries by adjusting for price level differences. 4. PPP eliminates the impact of exchange rate fluctuations and offers a better reflection of real living standards. 5. The International Monetary Fund (IMF) and the World Bank frequently use PPP to rank countries’ economies. 6. The Big Mac Index is a popular, informal measure of PPP, comparing the price of a Big Mac burger in various countries. 7. PPP theory assumes that, in the long run, exchange rates should adjust to equalize the price of goods globally. 8. Despite its usefulness, PPP is limited by factors like trade barriers, non-tradable goods, and local market differences.

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