Purchasing Power Parity (PPP)

Purchasing Power Parity (PPP) is an economic concept used to determine the relative value of different currencies. It’s not typically used directly in payments, but it does help understand the relative purchasing power across different countries, which can influence international business decisions, including payment strategies.

The principle behind PPP is that identical goods in different countries should cost the same, taking the exchange rate into account. If the goods are more expensive in one country, that country’s currency is considered overvalued compared to the other; if they’re cheaper, it’s undervalued.

Here’s how PPP can be beneficial and where it’s used:

  1. International Comparisons: PPP-adjusted figures are used to compare the economic output of different countries and make more accurate judgments about national wealth and living standards.
  2. Global Businesses: Companies operating in different countries can use PPP to help determine pricing strategies, salary scales, and investment decisions.
  3. International Organizations: Bodies like the World Bank, the International Monetary Fund (IMF), and the Organization for Economic Cooperation and Development (OECD) use PPP to compare the economic productivity and living standards of different countries.
  4. Economic Studies: Researchers use PPP when comparing international economic data, as it provides a more accurate comparison of economic productivity and standards of living.

PPP is calculated through the following general process:

  1. Select a basket of goods that is representative of each country’s economy.
  2. Find the cost of this basket of goods in each country.
  3. Divide the cost in one country by the cost in another country to derive the PPP exchange rate.
  4. Compare the PPP exchange rate with the market exchange rate to see if a currency is under- or over-valued.

PPP is used across the globe, but it’s particularly important when comparing developing economies with developed economies because market exchange rates may not fully reflect the domestic purchasing power of money in developing economies. Thus, it’s used widely in international economic organizations and research when dealing with global economic comparisons.

This page was last updated on May 22, 2023.

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