What is Purchasing power parity


and why is it important when compairing two countries’ Gross Domestic Product?

In: 1

It’s the difference between how much you can buy in two different places with the same amount of money.

In 2019, you could buy a Big Mac for $5 in the US, but in Hong Kong a Big Mac cost $20. In that interaction, Hong Kong had quadruple the GDP of the US, but they had the exact same production and consumption.

PPP measures that difference, and helps us adjust GDP to better represent how much an economy is doing.

ELI5, PPP is meant to adjust for varying prices of consumer goods in different locations. At a countrywide economy level, gross GDP is somewhat useful to compare across countries. However, the weakness of GDP is that it assumes that “$1 is $1 everywhere”. When trying to evaluate things like “quality of life” or “goods consumed by the individual”, that assumption is insufficient.

So a country with GDP twice that of another is twice as “productive” in dollar terms but that does not imply that their average citizen consumes twice as much as the other. The PPP is meant to try to adjust for this. So a PPP adjusted figure gives a better idea to compare the consumption of the average person. (It is “better” but rather subjective and this is a weakness of PPP – many more assumptions need to be made)

Purchasing power is the value of a currency to buy actually usable stuff. If you took 1 US Dollar and buy soda in USA then you get say 1 bottle. For the same 1 US dollar in India you get say 3 bottles. So now you paid the same amount of money but got different quantities of items. PPP will adjust for this and show you the standardized value of goods.

Here GDP of USA is 1 US dollar, and say this is the baseline
Then as per PPP the GDP of India is 3 US Dollars

On their own, GDP per capita might make it look like there is a HUGE difference in income/quality of life between certain countries. Say one country has GDP per capita of $40k and another has GDP per capita of $20k. So one country looks like it’s twice as wealthy as the other. But in terms of quality of life, if goods and services are cheaper in the second country the quality of life might not be as different as you might first assume. Maybe rents are half, maybe a bag of rice is half, maybe cars cost the same but there is cheap transit, etc. so that overall quality of life is only 10% lower in the country with half the GDP of the other.

Purchasing Power Parity (PPP) is a metric used to show how much you could buy when comparing the strength of currencies. It is imperative to use this to compare Gross Domestic Product to show differences in how many goods are available to purchase as well as how much of these goods can people purchase.