Purchasing Power Parity Example



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.

Purchasing power parity is defined as the number of units of a country’s currency required to buy the same amount of goods and services in the domestic market as one dollar would buy in the US. 
 Imagine that the market exchange rate between Dollar and Rupee is 60. One Dollar in the US will buy one liter of milk there. Corresponding money in terms of Rupee i.e., Rs 60 can buy three liters of milk in India.
 Suppose that India’s GDP is Rs 600. This will become $10 in market exchange rate terms. If milk is the only commodity produced in the world (you imagine it for simplicity sake), one will think that India is producing 10 liters of milk, if we use the market exchange rate.
Actually, India produces 30 liters of milk. This higher volume of production in India is not expressed if we use the market exchange rate to measure GDP.
To overcome this defect and to accurately measure the GDP, we can use the Purchasing Power Parity exchange rate.
Under PPP, we measure the GDP of India by measuring how much milk that Rupees 60 can purchase in India and One Dollar can purchase in the US.
Here, one dollar in the US can purchase one liter of milk whereas Rs 20 can purchase one liter of milk in India.
 $ 1    =        Rs 20
This is the purchasing power parity exchange rate we obtained. Using this exchange rate we can calculate that India’s GDP of Rs 600 will become $30.  
Thus, in terms of PPP, India’s GDP is $30 in contrast to the $10 we estimated by using market exchange rate.
The PPP exchange rates help to minimize misleading international comparisons that can arise with the use of market exchange rates.
The World Bank is using purchasing power parity conversion factor to correctly represent the PPP exchange rate. As per the WB estimate, 17.12 Indian Rupee is equal to one US Dollar in terms of purchasing power in 2014

Wednesday, 09th Aug 2017, 04:23:05 PM

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