what does purchasing power parity mean?

Question

what does purchasing power parity mean?

In: Economics

Answer 1

Let’s say you want to compare median family income in Guilder and Florin. In Guilder, median family income is 1000 lucres. In Florin, it’s 2000 whizbangs. So to compare, you gotta convert lucres and whizbangs.

You could use the exchange rate, how many whizbangs it costs to buy a lucre on the open market. If the exchange rate is 1.5 whizbangs for a lucre, then MFI in Guilder is 1000 lucres and in Florin it’s 1333. Families in Florin are somewhat better off.

But exchange rates can be manipulated by governments for their own purposes. So you might instead use PPP. A simple way to do this is to just divide the each MFI by the average cost of a Big Mac in each country. If you do this, you find the median family in Guilder earns 3800 Big Macs per year while the median family in Florin earns 3400. So looking at it this way, families in Guilder are better off.