Purchasing power parity

Purchasing power parity (PPP) attempts to measure the absolute purchasing power of a country’s currency, to indicate how over – or undervalued one currency is relative to another. and to help compare economic data between countries. It does this by comparing the price of identical goods in different economies. 

The idea is that a similar basket of goods should cost roughly the same wherever you go. If goods are cheaper in one country than in another, then that country should be able to export them to the other for a profit. In turn, those sales would boost demand for the exporter’s currency, driving the exchange rate higher, and eliminating the difference between the two. As a result, purchasing power between countries should tend towards parity in the long run. 

The “Big Mac index”, published by The Economist since 1986, is an example of a simple and popular PPP indicator. It shows the value of a McDonald’s Big Mac burger in US dollars, all across the globe. The index is not especially scientific, but since a Big Mac is a product that can be bought in almost any country and is comprised of the same input costs (raw materials and labour) and is distributed in almost exactly the same way wherever you go, it can be surprisingly good as an approximation. As of January 2024, the index had a Big Mac costing £4.49 in the UK and $5.69 in the US. 

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At the prevailing exchange rate at the time of $1.27 to the pound, that meant a Big Mac in the UK cost just over $5.70, implying the dollar was fairly valued relative to the pound. Serious measures of PPP compare the price of a broad basket of goods in the same way. Using PPP to adjust GDP figures can be a useful way for economists to compare GDP between nations without the distorting impact of relative currency valuations, which can make living costs look higher in developing countries than they really are.