What Is Purchasing Power Parity (PPP)?
The Purchasing Power Parity (PPP) is a theory that states that the foreign exchange rate between two countries should be equal to the ratio between their respective prices of a fixed basket of goods. When this holds, the exchange rate is said to be in equilibrium.
Calculating Purchasing Power Parity
The relative version of PPP is calculated with the following formula:
How Does Purchase Power Parity Work?
An economist will use the PPP to compare the economic output of different nations against one another. It might be used to determine which country has the world's largest economy. Using PPP exchange rates in addition to a country's gross domestic product (GDP) may help to provide a more detailed picture of a country's economic health.
The theoretical value is also helpful to traders in foreign currency and investors holding foreign stocks or bonds as it helps to predict fluctuations in international currency and indicate weakness.
Comparing a Country's Output
Purchasing power parity finds its most excellent use in macroeconomic studies as you compare GDP. Since many countries have their currency, GDP values can be skewed. PPP recalculates a country's GDP as if it were being priced in the United States.
The CIA World Factbook calculates PPP to compare output among countries. It is estimated that China's 2019 GDP was $22.5 trillion—much more than the U.S. GDP of $20.5 trillion. According to PPP, China has the world's largest economy.
However, without PPP, this comparison yields a different result. If you measure China's GDP in yuan, then convert that yuan to U.S. dollars at the market exchange rate, the country's 2019 GDP would only total roughly $14.3 trillion.