What is Purchasing Power Parity?
Macroeconomic analysis relies on several different metrics to compare economic productivity and standards of living between countries and across time....
Macroeconomic analysis relies on several different metrics to compare economic productivity and standards of living between countries and across time. One popular metric is purchasing power parity (PPP). Purchasing Power Parity (PPP) is an economic theory that compares different countries' currencies through a market "basket of goods" approach.
According to this concept, two currencies are in equilibrium or at par when a market basket of goods (taking into account the exchange rate) is priced the same in both countries. Every three years, the World Bank constructs and releases a report that compares 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.
Using PPPs is the alternative to using market exchange rates. The actual purchasing power of any currency is the quantity of that currency needed to buy a specified unit of a good or a basket of common goods and services. PPP is determined in each country based on its relative cost of living and inflation rates. Purchasing power plus parity ultimately means equalizing the purchasing power of two differing currencies by accounting for differences in inflation rates and cost of living.
One way to think of what GDP with PPP represents is to imagine the total collective purchasing power of Japan if it were used to make the same purchases in U.S. markets. This only works after all yen are exchanged for dollars, otherwise, the comparison does not make sense. The net effect is to describe how many dollars it takes to buy $1 worth of goods in Japan as opposed to in the US.
The five nations with the highest GDP in market exchange terms are the U.S., China, India, Japan, and Germany. This comparison changes when PPP is used. According to 2014 data from the International Monetary Fund (IMF), China has overtaken the U.S. as the world's largest economy based on purchasing power with just over 16.5% of the global GDP. The U.S. comes in second with 16.5%. India, Japan, and Germany follow with 6.8%, 4.5%, and 3.4% respectively.
(Courtesy: Investopedia; http://www.investopedia.com/updates/purchasing-power-parity-ppp/#ixzz4sBbO9oty)