- published: 28 Mar 2015
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Theories that invoke purchasing power parity assume that in some circumstances (for example, as a long-run tendency) it would cost exactly the same number of, for example, US dollars to buy euros and then to use the proceeds to buy a market basket of goods as it would cost to use those dollars directly in purchasing the market basket of goods.
The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be at par with the purchasing power of the two countries' currencies. Using that PPP rate for hypothetical currency conversions, a given amount of one currency thus has the same purchasing power whether used directly to purchase a market basket of goods or used to convert at the PPP rate to the other currency and then purchase the market basket using that currency. Observed deviations of the exchange rate from purchasing power parity are measured by deviations of the real exchange rate from its PPP value of 1.
Purchasing power (sometimes retroactively called adjusted for inflation) is the number of goods or services that can be purchased with a unit of currency. For example, if one had taken one unit of currency to a store in the 1950s, it is probable that it would have been possible to buy a greater number of items than would today, indicating that one would have had a greater purchasing power in the 1950s. Currency can be either a commodity money, like gold or silver, or fiat money emitted by government sanctioned agencies. Most modern fiat currencies like US dollars are traded against each other and commodity money in the secondary market for the purpose of international transfer of payment for goods and services. As Adam Smith noted, having money gives one the ability to "command" others' labor, so purchasing power to some extent is power over other people, to the extent that they are willing to trade their labor or goods for money or currency.
If one's monetary income stays the same, but the price level increases, the purchasing power of that income falls. Inflation does not always imply falling purchasing power of one's money income since it may rise faster than the price level. A higher real income means a higher purchasing power since real income refers to the income adjusted for inflation.
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Table of Contents: 00:00 - purchasing power parity 00:06 - comparing money values across countries 00:16 - Exchange rate method 01:24 - Your turn 02:25 - Purchasing Power Parity 03:38 - PPP, continued 03:46 - A PPP Example 05:34 - Another PPP example 05:35 - A PPP Example 05:39 - Another PPP example 06:48 - the Exchange Rate Method can also make countries look too rich 07:30 - GDP in ppp units 07:57 - PPP units and GDP per capita 08:20 - PPP vs. exchange rate methods 08:53 - The End
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Purchasing power parity (PPP) is a component of some economic theories and is a technique used to determine the relative value of different currencies. Theories that invoke purchasing power parity assume that in some circumstances (for example, as a long-run tendency) it would cost exactly the same number of, say, US dollars to buy euros and then to use the proceeds to buy a market basket of goods as it would cost to use those dollars directly in purchasing the market basket of goods. This video is targeted to blind users. Attribution: Article text available under CC-BY-SA Creative Commons image source in video
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