Purchasing Power Parity

Definition

Purchasing power parity (PPP) is an economic theory that states the exchange rate between two currencies is determined by the relative purchasing power of each currency in its home country. It suggests that the exchange rate adjusts so that an identical basket of goods and services has the same total cost when expressed in either currency, thus equalizing the purchasing power of the two currencies.

5 Must Know Facts For Your Next Test

1. Purchasing power parity is used to compare the living standards and economic productivity of different countries by adjusting for differences in price levels.
2. PPP exchange rates are often used to convert and compare gross domestic product (GDP) between countries, providing a more accurate assessment of economic output.
3. Deviations from PPP can be caused by trade barriers, transportation costs, government policies, and other market imperfections that prevent the equalization of prices across borders.
4. The Big Mac Index, developed by The Economist, is a popular PPP-based measure that compares the price of a McDonald's Big Mac across different countries.
5. Purchasing power parity is an important concept in international marketing, as it helps companies understand the relative purchasing power of consumers in different markets and develop appropriate pricing strategies.

Review Questions

• Explain how purchasing power parity (PPP) relates to exchange rates and international trade.
  • Purchasing power parity (PPP) is a theory that suggests exchange rates should adjust to equalize the purchasing power of different currencies, such that the same basket of goods and services would cost the same amount when expressed in either currency. This is based on the idea that exchange rates should reflect the relative purchasing power of currencies, rather than just their nominal values. PPP is important in international trade because it helps compare the real economic output and living standards of different countries, and can inform pricing and marketing strategies for companies operating in multiple markets.
• Describe how the Big Mac Index is used as a measure of purchasing power parity (PPP).
  • The Big Mac Index, developed by The Economist, is a popular PPP-based measure that compares the price of a McDonald's Big Mac across different countries. The underlying idea is that the price of a Big Mac should be the same in all countries, once converted to a common currency, if purchasing power parity holds true. By comparing the actual exchange rate to the PPP-implied exchange rate based on Big Mac prices, the Big Mac Index provides a simple and accessible way to assess whether a currency is overvalued or undervalued relative to another. This can be useful for companies evaluating the relative purchasing power of consumers in different markets and informing their pricing and marketing strategies.
• Analyze how deviations from purchasing power parity (PPP) can impact international marketing and business strategies.
  • Significant deviations from purchasing power parity (PPP) can have important implications for international marketing and business strategies. If a currency is undervalued relative to PPP, it suggests the local consumers have greater purchasing power than the exchange rate indicates. This may present opportunities for companies to price products more competitively and gain a market advantage. Conversely, if a currency is overvalued relative to PPP, it signals that local consumers have lower real purchasing power, which could require adjustments to pricing, product offerings, and marketing approaches to remain competitive. Understanding these PPP deviations is crucial for companies operating in multiple markets, as it allows them to more accurately assess the relative purchasing power of consumers and develop appropriate strategies to effectively serve those markets.

Related terms

Exchange Rate: The price of one currency in terms of another, used to facilitate international transactions and compare the relative values of different currencies.

Inflation: The sustained increase in the general price level of goods and services in an economy over time, which erodes the purchasing power of a currency.

Arbitrage: The practice of taking advantage of a price difference between two or more markets, striking a combination of matching deals to capitalize on the imbalance.