Parities is the section of the Currencies division regarding the indicators that measure the relative money power of the world countries that are useful to understand the overvaluation/undervaluation of the currencies in term of the relative economic wealth.
The two indicators that are reported in this section are:
- Purchasing Power Parity as measured and published by OCSE.
- Big Mac Index as measured and published by The Economist.
Purchasing Power Parity (PPP)
Purchasing power parities (PPPs) are the rates of currency conversion that try to equalise the purchasing power of different currencies, by eliminating the differences in price levels between countries. The basket of goods and services priced is a sample of all those that are part of final expenditures: final consumption of households and government, fixed capital formation, and net exports. This indicator is measured in terms of national currency per US dollar. (OCSE)
Purchasing power parity (PPP) is measured by finding the values (in USD) of a basket of consumer goods that are present in each country (such as pineapple juice, pencils, etc.). If that basket costs $100 in the US and $200 in the United Kingdom, then the purchasing power parity exchange rate is 1:2 (0,5).
What Is Purchasing Power Parity (PPP), and How Is It Calculated?
By THE INVESTOPEDIA TEAM
Updated March 08, 2022
Reviewed by MICHAEL J BOYLE, Fact checked by PETE RATHBURN
One popular macroeconomic analysis metric to compare economic productivity and standards of living between countries is purchasing power parity (PPP). PPP is an economic theory that compares different countries' currencies through a "basket of goods" approach.
Image by Sabrina Jiang © Investopedia 2020
According to this concept, two currencies are in equilibrium—known as the currencies being at par—when a basket of goods is priced the same in both countries, taking into account the exchange rates.
- Purchasing power parity (PPP) is a popular metric used by macroeconomic analysts that compares different countries' currencies through a "basket of goods" approach.
- Purchasing power parity (PPP) allows for economists to compare economic productivity and standards of living between countries.
- Some countries adjust their gross domestic product (GDP) figures to reflect PPP.
Calculating Purchasing Power Parity
The relative version of PPP is calculated with the following formula:
Comparing Nations' Purchasing Power Parity
To make a meaningful comparison of prices across countries, a wide range of goods and services must be considered. However, this one-to-one comparison is difficult to achieve due to the sheer amount of data that must be collected and the complexity of the comparisons that must be drawn. To help facilitate this comparison, the University of Pennsylvania and the United Nations joined forces to establish the International Comparison Program (ICP) in 1968.
With this program, the PPPs generated by the ICP have a basis from a worldwide price survey that compares the prices of hundreds of various goods and services. The program helps international macroeconomists estimate global productivity and growth.
Every few years, the World Bank releases a report that compares the productivity and growth of various countries in terms of PPP and U.S. dollars.
Both the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD) use weights based on PPP metrics to make predictions and recommend economic policy.
The recommended economic policies can have an immediate short-term impact on financial markets.
Also, some forex traders use PPP to find potentially overvalued or undervalued currencies. Investors who hold stock or bonds of foreign companies may use the survey's PPP figures to predict the impact of exchange-rate fluctuations on a country's economy, and thus the impact on their investment.
Pairing Purchasing Power Parity With Gross Domestic Product
In contemporary macroeconomics, gross domestic product (GDP) refers to the total monetary value of the goods and services produced within one country. Nominal GDP calculates the monetary value in current, absolute terms. Real GDP adjusts the nominal gross domestic product for inflation.
However, some accounting goes even further, adjusting GDP for the PPP value. This adjustment attempts to convert nominal GDP into a number more easily comparable between countries with different currencies.
To better understand how GDP paired with purchase power parity works, suppose it costs $10 to buy a shirt in the U.S., and it costs €8.00 to buy an identical shirt in Germany. To make an apples-to-apples comparison, we must first convert the €8.00 into U.S. dollars. If the exchange rate was such that the shirt in Germany costs $15.00, the PPP would, therefore, be 15/10, or 1.5.
In other words, for every $1.00 spent on the shirt in the U.S., it takes $1.50 to obtain the same shirt in Germany buying it with the euro.
GDP by Purchasing Power Parity vs Nominal GDP
Drawbacks of Purchasing Power Parity
Since 1986, The Economist has playfully tracked the price of McDonald's Corp.’s (MCD) Big Mac hamburger across many countries. Their study results in the famed "Big Mac Index". In "Burgernomics"—a prominent 2003 paper that explores the Big Mac Index and PPP—authors Michael R. Pakko and Patricia S. Pollard cited the following factors to explain why the purchasing power parity theory is not a good reflection of reality.
- Transport Costs. Goods that are unavailable locally must be imported, resulting in transport costs. These costs include not only fuel but import duties as well. Imported goods will consequently sell at a relatively higher price than do identical locally sourced goods.
- Tax Differences. Government sales taxes such as the value-added tax (VAT) can spike prices in one country, relative to another.
- Government Intervention. Tariffs can dramatically augment the price of imported goods, where the same products in other countries will be comparatively cheaper.
- Non-Traded Services. The Big Mac's price factors input costs that are not traded. These factors include such items as insurance, utility costs, and labor costs. Therefore, those expenses are unlikely to be at parity internationally.
- Market Competition. Goods might be deliberately priced higher in a country. In some cases, higher prices are because a company may have a competitive advantage over other sellers. The company may have a monopoly or be part of a cartel of companies that manipulate prices, keeping them artificially high.
The Bottom Line
While it's not a perfect measurement metric, purchase power parity does allow for the possibility of comparing pricing between countries that have differing currencies.
Big Mac Index
Article from Wikipedia, the free encyclopedia
The Big Mac Index is a price index published since 1986 by The Economist as an informal way of measuring the purchasing power parity (PPP) between two currencies and providing a test of the extent to which market exchange rates result in goods costing the same in different countries. It "seeks to make exchange-rate theory a bit more digestible." The index compares the relative price worldwide to purchase the Big Mac, a hamburger sold at McDonald's restaurants.
- The Big Mac Index was created to measure the disparities in consumer purchasing power between nations.
- The burger replaces the "basket of goods" traditionally used by economists to measure differences in consumer pricing.
- The index was created with tongue in cheek but many economists say it's roughly accurate.
The Big Mac index was introduced in The Economist in September 1986 by Pam Woodall as a semi-humorous illustration of PPP and has been published by that paper annually since then. Although the Big Mac Index was not intended to be a legitimate tool for exchange rate evaluation, it is now globally recognised and featured in many academic textbooks and reports. The index also gave rise to the word burgernomics.
The theory underpinning the Big Mac index stems from the concept of PPP, which states that the exchange rate between two currencies should equalize the prices charged for an identical basket of goods. However, in reality, sourcing an identical basket of goods in every country provides a complex challenge. According to the Organisation for Economic Co-operation and Development (OECD), over "3,000 consumer goods and services, 30 occupations in government, 200 types of equipment goods and about 15 construction projects" are included in the current PPP calculations. In effort to simplify this important economic concept, The Economist proposed that a single McDonald’s Big Mac could be used instead of a basket of goods. A McDonald’s Big Mac was chosen because of the prevalence of the fast food chain worldwide, and because the sandwich remains largely the same across all countries. Although a single sandwich may seem overly simplistic for PPP theory, the price of a Big Mac is derived from the culmination of "many local economic factors, such as the price of the ingredients, local wages, or how much it costs to put up billboards and buy TV ads". As a result, the Big Mac index provides a "reasonable measure of real-world purchasing power".
The purpose of the Big Mac index is to calculate an implied exchange rate between two currencies. In order to calculate the Big Mac index, the price of a Big Mac in a foreign country (in the foreign country’s currency) is divided by the price of Big Mac in a base country (in the base country’s currency). Typically, the base country used is the United States.
For example, using figures from January 2022:
In Switzerland, a Big Mac costs 6.50 Swiss franc.In the US, a Big Mac costs $5.81 USD.The implied exchange rate is 1.12 SFr/USD, that is 6.50SFr/$5.81USD = 1.12.
Consistent with PPP economic theory, the Big Mac index also provides a method to analyse a currency’s level of under/over-valuation against a base currency. In order to calculate whether a currency is under/over-valued, the implied exchange rate (as defined by the Big Mac index) must be compared to the actual exchange rate. If the implied exchange rate is greater than the actual exchange rate, then the analysed currency is overvalued against the base currency. If the implied exchange rate is less than the actual exchange rate, then the analysed currency is undervalued against the base currency.
- iPod index: Just like the Big Mac Index, in 2007, an Australian bank introduced the iPod Index. But the theory ignores shipping and distribution costs, which may vary from one country to another, depending upon the distance of the country from the place of manufacture.
- Gold Mac Index: In this index, purchasing power parity is calculated on the basis of how many burgers can be purchased with one gram of gold in a particular country.
Understanding the Big Mac Index
According to PPP theory, any change in the exchange rate between nations should be reflected in a change in the price of a basket of goods.
The Big Mac Index Video
One of the key insights of the Big Mac Index is that a basket of goods in one country can rarely be precisely duplicated in another country. For example, an American basket of groceries and a Japanese basket of groceries are likely to contain very different products. A Big Mac, though, is always a Big Mac, allowing for slight local differences in ingredients.
The editors of The Economist editors stress that the index should not be taken too seriously. "Burgernomics was never intended as a precise gauge of currency misalignment, merely a tool to make exchange-rate theory more digestible," an article on the site indicates.
Criticisms of the Big Mac Index:
Despite being a reasonable real-world measurement, some economists criticize this index. The index’s limitations are as follows:
- In many countries, dining at McDonald’s is relatively expensive when compared to dining at a local restaurant. Hence, the demand for a burger is relatively less. Hence, it doesn’t stand as globally acceptable.
- The total price of a Big Mac burger will be dependent upon local production, delivery cost, advertising costs, transportation costs, and the status of the local market, which will be different among countries and not be a reflection of overall relative currency values.
- The high volume and low margin approach generally taken by McDonald’s determines the profit range in many markets. In some places, a high margin approach maximizes the profit. Hence, the value determined will not reflect the fair currency status.
- The prices of a Big Mac also vary with the areas in which it is sold. Therefore, a Big Mac sold in a major city might be more expensive than one sold in a somewhat rural area.
'Big Mac Index' explained
Economy of Big Mac