Purchasing Power Parity – PPP

Both NCEA and CIE courses cover purchasing power parity (PPP). This is when an amount of money in one country can be exchanged for a quantity of foreign currency, and the two amounts will buy identical baskets of products in both countries.

Using a PPP basis is arguably more useful when comparing generalised differences in living standards on the whole between nations because PPP takes into account the relative cost of living and the inflation rates of the countries, rather than using only exchange rates, which may distort the real differences in income.

For example – Malaysia and the USA Market exchange rate 6 Malaysian ringgits (MYR) = US$1 USA has a real GDP per head of $50,000 Malaysia has a real GDP of MYR12,000.   MYR12,000 = $2,000 therefore on average people in the USA are 25 times better off than people in Malaysia – 50,000 / 2000 = 25.   However, if $1 can buy more goods and services in the USA than in Malaysia, then using the exchange rate to convert ringgits into dollars will exaggerate Malaysia’s output.   A basket of products may sell for $200 in the USA A basket of products may sell for MYR2,400 in Malaysia   This would mean that in terms of ability to buy products (purchasing parities) MYR12 are worth $1.  (2,400 / 200 = 12)   Using this as the basis for converting Malaysia’s output into US dollars would show that people in the USA are 50 times better off than people in Malaysia -. See below:   Market exchange rate MYR6 = $1 Basket of products rate MYR12 = $1

MYR12,000/12 = $1000. $50,000 / $1000 = 50   Even if a country is found to have a higher real GDP per head than another country using purchasing power parities, it does not necessarily mean that its inhabitants will enjoy higher living standards.

For more on Purchasing Power Parity view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.