Key Points
PPP compares currencies by analyzing the cost of a basket of goods in different countries. Using PPP, one can conclude which currency has the greatest purchasing power.
PPP is necessary for an objective perception of GDP and how effectively money is used in different regions. This can provide a clearer understanding of the standard of living and economic state of a country.
PPP may be indirectly related to the world of cryptocurrencies: this indicator allows conclusions to be drawn about how interested people in countries with weaker currencies are in cryptocurrencies and stablecoins as a means of protecting their purchasing power.
Introduction
Have you ever wondered why one item costing $10 in the USA may be much cheaper in another country? The concept of purchasing power parity (PPP) helps answer this question. Economists use PPP to compare the purchasing power of different currencies around the world.
Simply put, PPP helps determine how many goods can be purchased for a certain amount of money in different places. Whether it’s a cup of coffee in Brazil or a pair of sneakers in Germany, PPP allows for an objective price comparison across countries.
Let’s take a closer look at how this concept works and why it is important for understanding the global economy.
How PPP Works
So, the idea of purchasing power parity is based on the so-called law of one price. It is believed that in the absence of borders, the price of identical goods would be the same everywhere (considering exchange rates).
Let’s assume we want to buy a phone. If the exact same phone costs $500 in the USA and 55,000 yen in Japan, then according to PPP, the exchange rate would be 110 yen for each US dollar. Quite simple, isn’t it?
Of course, in reality, things are a bit more complicated. Taxes, shipping costs, local demand, and other factors also affect the price of goods in different places. It is not enough to simply compare the price of a single item in two countries. That’s why economists use a basket of goods, including food, clothing, housing, and electricity - essential categories of household expenditure. By comparing prices in this basket, one can determine the relative strength of different currencies.
The Importance of PPP
PPP is used not only by economists. This measure is particularly useful when measuring a country's economy and standard of living. In the context of gross domestic product (GDP) of a country, that is, its production volume, PPP is used to adjust for price differences between countries. This can provide an objective understanding of how much people actually earn and spend.
Take India, for example. Its GDP per capita may seem low when using ordinary exchange rates. However, when considering PPP and the lower cost of living in the country, we can draw different conclusions. Now, the average income in India looks more comparable to that in other countries, providing a more objective understanding of the overall standard of living.
Organizations like the International Monetary Fund (IMF) and the World Bank use GDP adjusted for PPP to get a clearer picture of global income distribution.
Comparing Standards of Living
PPP is useful in that it helps compare the standard of living in different countries. Adjusting for local prices, one can conclude how high a person's salary would be considered in another country. For example, $50,000 a year may provide a comfortable lifestyle in one country, but barely suffice for survival in another.
Long-term Exchange Rate Forecasts
Exchange rates can fluctuate up and down for various reasons, whether it be politics, stock markets, and more. However, over time, they generally tend to converge towards PPP data. Using this measure, economists make long-term forecasts about how currencies will behave.
Exposing Economic Manipulations
Sometimes governments adjust official exchange rates to create the impression of a stronger currency than it actually is. In such situations, when currencies do not reflect their true value, PPP can provide objective data.
Real Examples of PPP: Big Macs and iPads
You may have heard of the Big Mac Index. It’s a fun and simple example of using PPP proposed by The Economist. The idea is simple: since Big Macs from McDonald's are virtually identical in all countries, comparing their price allows for a quick assessment of the purchasing power of different currencies. If a Big Mac costs $5 in the USA and only $3 in India, that reflects the value of the two countries' currencies.
Over time, other similar methods of comparison have emerged, such as the iPad or KFC indices. They use everyday items and offer a straightforward example of applying PPP in real life.
Problems and Disadvantages of PPP
No matter how useful PPP is, it is not without its drawbacks. One of the main issues relates to the quality of goods. For example, a product in one country may cost more because it is of higher quality, even if they appear identical at first glance. Thus, price comparisons are not always fully objective.
Another potential drawback concerns non-tradable goods. Some of these, such as real estate or local services (like haircuts or electricity), are not sold internationally. Their prices can vary significantly depending on local conditions.
Inflation and time sensitivity can also complicate analysis. PPP assumes that prices will remain relatively stable over time; however, inflation can change everything. A price comparison made today may become outdated in just a few months.
Cryptocurrencies and PPP
Although purchasing power parity and cryptocurrency markets are not directly related, unlike traditional forex markets, PPP allows conclusions to be drawn about how people in different countries perceive and interact with cryptocurrencies.
Bitcoin and other cryptocurrencies are global assets that can be used in any country. However, in countries with weak currencies (according to PPP), cryptocurrencies may become a more expensive asset, making them a potential hedge against currency devaluation. This is especially relevant in countries that have experienced hyperinflation.
In countries with weaker currencies and high inflation, stablecoins offer people the opportunity to preserve their purchasing power: in such regions, they become sought-after and practical financial instruments. Although stablecoins also come with their risks, PPP helps determine whether it is beneficial to convert local currency into stablecoins in such cases.
In Conclusion
Purchasing power parity is a powerful tool for understanding global prices, income levels, and economies. Although it is not without its shortcomings, PPP allows for objective comparisons of economic indicators and strengths among different countries.
The ability to work with PPP will be useful for many people, whether they are economists trying to predict exchange rates, business representatives developing pricing strategies, or simply curious travelers noticing that some goods are more expensive or cheaper abroad.
Recommended Literature
What is Forex Trading?
What is Inflation?
What are Stablecoins?
What is the Carry Trade Strategy and How Does It Work?
Disclaimer: The following materials are provided without any guarantees solely for general reference and educational purposes. This information should not be considered as financial, legal advice, or a recommendation to purchase any specific product or service. You should independently seek advice from relevant professional consultants. Since the article is written by a third-party author, please note that the opinions expressed belong to the third-party author and do not necessarily reflect the views of Binance Academy. For more detailed information, please follow the link. The value of digital assets can be volatile. The value of invested funds can increase or decrease. You may not get back the invested funds. You take full responsibility for your investment decisions. Binance Academy is not responsible for any potential losses you may incur. This information is not financial, legal, or professional advice. To learn more, please review our Terms of Use and Risk Warning.
