Editing Purchasing power parity (section)

==Concept==

Purchasing power parity is an [[Economics|economic]] term for measuring prices at different locations. It is based on the [[law of one price]], which says that, if there are no [[transaction cost]]s nor [[trade barrier]]s for a particular good, then the price for that good should be the same at every location.<ref name="Krugman2">{{cite book|last=Krugman and Obstfeld|title=International Economics|year=2009|publisher=Pearson Education, Inc.}}</ref> Ideally, a computer in New York and in Hong Kong should have the same price. If its price is 500 [[United States dollar|US dollars]] in New York and the same computer costs 2,000 [[Hong Kong dollar|HK dollars]] in Hong Kong, PPP theory says the exchange rate should be 4 HK dollars for every 1 US dollar.

Poverty, tariffs, transportation, and other frictions prevent the trading and purchasing of various goods, so measuring a single good can cause a large error. The PPP term accounts for this by using a [[Market basket|basket of goods]], that is, many goods with different quantities. PPP then computes an inflation and exchange rate as the ratio of the price of the basket in one location to the price of the basket in the other location. For example, if a basket consisting of 1 computer, 1 ton of rice, and half a ton of steel was 1000 US dollars in New York and the same goods cost 6000 HK dollars in Hong Kong, the PPP exchange rate would be 6 HK dollars for every 1 US dollar.

The name ''purchasing power parity'' comes from the idea that, with the right exchange rate, consumers in every location will have the same [[purchasing power]].

The value of the PPP exchange rate is very dependent on the basket of goods chosen. In general, goods are chosen that might closely obey the law of one price. Thus, one attempts to select goods which are traded easily and are commonly available in both locations. Organizations that compute PPP exchange rates use different baskets of goods and can come up with different values.

The PPP exchange rate may not match the market exchange rate. The market rate is more [[Volatility (finance)|volatile]] because it reacts to changes in demand at each location. Also, tariffs and differences in the price of labour (see [[Balassa–Samuelson theorem]]) can contribute to longer-term differences between the two rates. One use of PPP is to predict longer-term exchange rates.

Because PPP [[exchange rate]]s are more stable and are less affected by tariffs, they are used for many international comparisons, such as comparing countries' GDPs or other national income statistics. These numbers often come with the label ''PPP-adjusted''.

There can be marked differences between purchasing power adjusted incomes and those converted via market exchange rates.<ref>{{cite web|url=http://www.ft.com/cms/s/0/36a2d566-ad82-11dc-9386-0000779fd2ac.html |archive-url=https://ghostarchive.org/archive/20221210/http://www.ft.com/cms/s/0/36a2d566-ad82-11dc-9386-0000779fd2ac.html |archive-date=2022-12-10 |url-access=subscription |url-status=live|title=China, India economies '40% smaller'|first=Scheherazade|last= Daneshkhu|date=18 December 2007|work=Financial Times}}</ref> A well-known purchasing power adjustment is the [[International dollar|Geary–Khamis dollar]] (the ''GK dollar'' or ''international dollar''). The [[World Bank|World Bank's]] ''World Development Indicators 2005'' estimated that in 2003, one Geary–Khamis dollar was equivalent to about 1.8 [[Renminbi|Chinese yuan]] by purchasing power parity<ref>[http://devdata.worldbank.org/wdi2005/Table5_7.htm 2005 World Development Indicators: Table 5.7 | Relative prices and exchange rates] {{webarchive|url=https://web.archive.org/web/20070223140429/http://devdata.worldbank.org/wdi2005/Table5_7.htm |date=2007-02-23 }}</ref>—considerably different from the nominal exchange rate. This discrepancy has large implications; for instance, when converted via the nominal exchange rates, [[List of countries by GDP (nominal) per capita|GDP per capita]] in [[India]] is about [[United States dollar|US$]]1,965<ref>[[List of countries by past and future GDP (nominal)]]</ref> while on a PPP basis, it is about Int$7,197.<ref>[[List of countries by future GDP (PPP) per capita estimates]]</ref> At the other extreme, [[Denmark|Denmark's]] nominal GDP per capita is around US$53,242, but its PPP figure is Int$46,602, in line with other [[developed nations]].

===Variations===

There are variations in calculating PPP. The EKS method (developed by Ö. Éltető, P. Köves and B. Szulc) uses the [[geometric mean]] of the exchange rates computed for individual goods.<ref>{{cite web |title=EKS Method |url=https://stats.oecd.org/glossary/detail.asp?ID=5525 |publisher=OECD |access-date=2019-08-26 |archive-date=2019-06-24 |archive-url=https://web.archive.org/web/20190624055426/https://stats.oecd.org/glossary/detail.asp?ID=5525 |url-status=dead }}</ref> The EKS-S method (by Éltető, Köves, Szulc, and Sergeev) uses two different baskets, one for each country, and then averages the result.  While these methods work for 2 countries, the exchange rates may be inconsistent if applied to 3 countries, so further adjustment may be necessary so that the rate from currency A to B times the rate from B to C equals the rate from A to C.

===Relative PPP===

{{Main|Relative purchasing power parity}}

Relative PPP is a weaker statement based on the law of one price, covering changes in the exchange rate and inflation rates. It seems to mirror the exchange rate closer than PPP does.<ref name=Burgernomics>{{cite web |last1=Pakko |first1=Michael |title=Burgernomics |url=https://files.stlouisfed.org/files/htdocs/publications/review/03/11/pakko.pdf |website=St. Louis Federal Reserve Bank |series=Research Division Publications (Federal Reserve Bank of St. Louis) |date=2 March 1917 |access-date=24 August 2019}}</ref>