What are PPP adjustments and why do we need them? (2024)

By: Esteban Ortiz-Ospina and Marco Molteni

March 16, 2017

Cite this articleReuse our work freely

Measuring economic activity in a country is difficult, since 'the economy' is a complex system with lots of moving parts. A common way to deal with this is to focus on aggregate indicators, such as total national output: "the monetary value of all goods and services produced within a country (or region) in a specific time period". That’s what economists call the Gross Domestic Product (GDP).

GDP is measured using prevailing national prices to estimate the value of output. In other words, GDP is calculated using local currency units. This means that in order to make meaningful cross-country comparisons, it is necessary to translate figures into a common currency - i.e. use a consistent 'unit of measure'.

One option is to simply translate all national figures into one common currency (for instance, US dollars) using exchange rates from currency markets. But because market exchange rates do not always reflect the different price levels between countries, economists often opt for a different alternative. They create a hypothetical currency, called ‘international dollars’, and use this as a common unit of measure. The idea is that a given amount of international dollars should buy roughly the same amount – and quality – of goods and services in any country.

The exchange rates used to translate monetary values in local currencies into 'international dollars' (int-$) are the 'purchasing power parity conversion rates' (also called PPP conversion factors). Below we discuss where PPP rates come from, and why they can often be more useful for comparisons than market exchange rates.

What is purchasing power and why does it matter?

Why do many British pensioners decide to move to Southern Spain? It’s not just about the weather. It also has to do with differences in price levels, which are lower in Spain than Britain. You can buy more things with one sterling pound in Southern Spain than you can in England. In other words, the purchasing power of the British Pound is higher in Spain than in England. This difference in price levels is exactly what PPP conversion rates try to capture.

If we are interested in living standards, any monetary income should be considered in relation to the amount of goods and services that it can buy locally. The same type of meal in the same type of restaurant has a different cost depending on the country where it is sold. This matters for macroeconomic comparisons and it matters for travelers: travel guides try to provide tourists with cross-country examples of differences in costs of living, and for one very specific product it is also what the Big Mac Index captures.

The following visualization shows cross-country differences in purchasing power, taking the US as the reference country. To be specific, the figures below correspond to the price level ratio of PPP conversion factors to market exchange rates. Hence, numbers below 1 imply that if you exchange 1 dollar at the corresponding market exchange rate, the resulting amount of money in local currency will buy you more in that country than you could have bought with one dollar in the US in the same year.

Click to open interactive version

A price level of 0.5 shown for a country in this map means that for a given sum of US dollars you can buy twice as many goods and services in that country than in the US. In countries with a price level above 1, you can buy fewer goods and services than in the US for a given sum of US dollars.

As we can see, price level differences between developed and developing countries are much larger than those between Spain and England. The amount of goods and services that you can buy with 500 US dollars in the US is very different to what you can buy with 500 US dollars in rural India.

This is important beyond GDP. Price level differences imply that with the same income in US dollars, you could be on the verge of poverty in the US, or fairly well-off in rural India. For this reason, we need to consider purchasing power when comparing variables such as poverty rates between countries.

From the explanation above it should be clear that we need to control for price differentials in order to meaningfully compare GDP between countries. We need a conversion factor that achieves purchasing power parity.

If we take an all-embracing basket of goods and services and use it as a reference point, we can compute price indices for each country and, using statistical methods, adjust the GDP figures to deal with the problem of different price levels.

This is exactly what purchasing power parity does. It's an exercise that is done by the International Comparison Programme (ICP). Angus Deaton explains it as follows: "Purchasing power parity exchange rates, or PPPs, are price indexes that summarize prices in each country relative to a numeraire country, typically the United States. These numbers are used to compare living standards across countries, by academics in studies of economic growth, particularly through the Penn World Table, by the World Bank to construct measures of global poverty, by the European Union to redistribute resources, and by the international development community to draw attention to discrepancies between rich and poor countries."

Using PPP-adjusted international dollars can make a huge difference

As the chart here shows, using PPP-adjusted international dollars rather than US market dollars as a unit of measure can make a huge difference. When price levels in a country are much lower than in the US, using US dollars at market exchange rates will significantly underestimate the standard of living when measured through GDP per capita.

Click to open interactive version

Why are differences in price levels not reflected in currency market exchange rates?

For two countries – A and B – the two different currencies allow for different comparisons. The market exchange rate tells you how many units of currency from country B you can buy with a unit of currency A. The purchasing power parity conversion factor, on the other hand, takes the relative prices between countries into account and allows for comparisons when you want to know how many currency units you have to spend to buy the same amount of goods and services in each of the two countries.

So, why are these two things not the same? This is not a trivial question. There are good reasons why the market exchange rate between two currencies should reflect the relative price levels between the two economies. Imagine that one apple costs $1 in the US and £1 in the UK. Suppose the market exchange rate is not 1:1, but for example $1.5 = £1. Given this situation, an American person with an apple would have an incentive to sell the apple in the UK, and then convert pounds into dollars, making a profit. This is what is called arbitrage. People would jump at such opportunities, and before long, market forces would exhaust gains from trade, leading to an equilibrium where currency prices and apple prices adjust and there are no opportunities to engage in this 'free-money game'.

The above logic, however, assumes that goods and services are tradable internationally. But in reality there are goods and services that cannot be traded internationally. If you have a house in London, you cannot export that house to the US or China. There are many other examples of non-tradable goods, such as public roads, basic services such as schooling, or even more trivial services such as hair-cuts.

The issue is that if you live in Scotland, you do not care about the price of schools in Northern Italy, or rents in Southern Spain. And this matters in the context of our discussion because prices of non-tradable goods affect the general price level of a country; but prices of non-tradable goods are determined mainly by domestic dynamics. This is one reason why we observe cross-country differences in price levels that are not mirrored by corresponding differences in currency prices.

Why do rich countries tend to have higher prices?

Empirically, we observe that prices are higher in richer countries: there is a positive cross-country relationship between average incomes and average prices. This can be seen in the visualization below, which plots GDP per capita (in international dollars) against price levels (relative to the US). This observation was formalized by Balassa and Samuelson in the 1960s, and is usually referred to as the 'Penn effect'.

Click to open interactive version

Pinning down the causes behind the Penn effect is not straightforward; but economic theory provides some hints.

One possible explanation, which has received substantial attention in the academic literature, rests on cross-country productivity differences; specifically, the fact that labor tends to be more productive in rich countries because of the adoption of more advanced technologies.

This is the essence of the 'Balassa-Samuelson model'. The greater the productivity differentials in the production of tradable goods between countries, the larger the differences in wages and prices of services; and correspondingly, the greater the gap between purchasing power parity and the equilibrium exchange rate. If international productivity differences are greater in the production of tradable goods than in the production of non-tradable goods, the currency of the country with the higher productivity will appear to be overvalued in terms of purchasing power parity. Therefore, the ratio of purchasing power parity to the exchange rate will be an increasing function of income.1

The correlation between productivity and the price level can be seen in this scatter plot here.

What are the main limitations of PPP adjustments?

The last rounds of PPP factors estimated by the International Comparison Programme (ICP) are from 2005, 2011 and 2017. With every release, estimates improve. But the data limitations have to be kept in mind, particularly if we consider the stakes: international institutions, charities and governments rely on PPP factors in order to design policies and allocate resources internationally.

What are the main limitations?

First, there are issues with the underlying sources used by the ICP. Many low-income countries do not collect sufficiently rich data on price levels, so the ICP often needs to impute missing values by making extrapolations based on regional averages, or by relying on data from price levels in capital cities where prices are often higher than in rural parts of the country.

And second, differences in consumption and production patterns make the identification of a common 'standard' basket of goods difficult and arbitrary. Agreeing on broad categories (e.g. 'food') is relatively easy; but narrowing down the exact items is much more complicated, since allowances have to be made for differences in factors such as product quality. Hence, the actual items that should be included in the 'standard basket' of goods produced and consumed in, say Sweden, are very different to those that should be included in Saudi Arabia.

Endnotes

  1. You can read more about the Balassa-Samuelson model in the corresponding Wikipedia entry. Or, for a more technical discussion, you can read Asea P.K., Corden W.M., 1994, The Balassa-Samuelson Model: An Overview', Review of International Economics, 2:3, pp.191-200 (available online here).

Cite this work

Our articles and data visualizations rely on work from many different people and organizations. When citing this article, please also cite the underlying data sources. This article can be cited as:

Esteban Ortiz-Ospina and Marco Molteni (2017) - “What are PPP adjustments and why do we need them?” Published online at OurWorldInData.org. Retrieved from: 'https://ourworldindata.org/what-are-ppps' [Online Resource]

BibTeX citation

@article{owid-what-are-ppps, author = {Esteban Ortiz-Ospina and Marco Molteni}, title = {What are PPP adjustments and why do we need them?}, journal = {Our World in Data}, year = {2017}, note = {https://ourworldindata.org/what-are-ppps}}

What are PPP adjustments and why do we need them? (4)

Reuse this work freely

All visualizations, data, and code produced by Our World in Data are completely open access under the Creative Commons BY license. You have the permission to use, distribute, and reproduce these in any medium, provided the source and authors are credited.

The data produced by third parties and made available by Our World in Data is subject to the license terms from the original third-party authors. We will always indicate the original source of the data in our documentation, so you should always check the license of any such third-party data before use and redistribution.

All of our charts can be embedded in any site.

What are PPP adjustments and why do we need them? (2024)

FAQs

What are PPP adjustments and why do we need them? ›

PPP allows economists to compare economic productivity and standards of living between countries. Some countries adjust their gross domestic product (GDP) figures to reflect PPP. Some feel that PPP does not reflect reality due to differences in local costs, taxes, tariffs, and competition.

What is the reason for measuring PPP? ›

Purchasing power parity (PPP) is a measure of the price of specific goods in different countries and is used to compare the absolute purchasing power of the countries' currencies.

Why is PPP essential? ›

Provide better infrastructure solutions.

This is particularly true in developing communities and countries. These partnerships help citizens not only get access to much-needed services but can also facilitate economic growth. Areas with better infrastructure attract more businesses, which creates more jobs.

What is purchasing power parity in simple words? ›

Purchasing power parity (PPP) is an economic theory of exchange rate determination. It states that the price levels between two countries should be equal. This means that goods in each country will cost the same once the currencies have been exchanged.

What is the meaning of PPP? ›

Purchasing power parity (PPP) is a money conversion rate used to express the purchasing powers of different currencies in common units. This rate expresses the ratio between the quantity of monetary units required in different countries to purchase the same "basket" of goods and services.

What is PPP and why is it important? ›

Purchasing power parity (PPP) is a popular metric used by macroeconomic analysts that compares different countries' currencies through a "basket of goods" approach. PPP allows economists to compare economic productivity and standards of living between countries.

Why is PPP required? ›

Private sector is cost-effective: PPPs provide incentives for private sector companies to innovate and find cost-effective solutions and put to use their expertise in developing and maintaining infrastructure.

What is the primary purpose of PPP? ›

The Paycheck Protection Program allows entities to apply for low-interest private loans to pay for payroll and certain other costs. A PPP loan amount is approximately equal to 2.5 times the applicant's average monthly payroll costs.

Why is PPP useful? ›

Advantages of PPP: A main one is that PPP exchange rates are relatively stable over time. By contrast, market rates are more volatile, and using them could produce quite large swings in aggregate measures of growth even when growth rates in individual countries are stable.

What is the main problem with PPP? ›

This paper explores nine key challenges in PPP implementation: (1) different organizational cultures and goals between the partners, (2) poor institutional environment and support, (3) weak political and legal frameworks, (4) unreliable mechanisms for sharing risk and responsibility, (5) inadequate procedures for the ...

Is PPP a good measure? ›

For measuring overall well-being, Purchasing Power Parity (PPP) is considered as a good indicator.

What are the criticism of purchasing power parity theory? ›

Keynes' Critique: According to Keynes, there are two basic defects in the purchasing power parity theory, namely: (i) It does not take into consideration the elasticity's of reciprocal demand. (ii) It ignores the influences of capital movements.

Which country has the highest purchasing power parity? ›

Luxembourg

What are the benefits of PPP? ›

PPP advantages:
  • Ensure the necessary investments into public sector and more effective public resources management;
  • Ensure higher quality and timely provision of public services;
  • Mostly investment projects are implemented in due terms and do not impose unforeseen public sectors extra expenditures;
Nov 12, 2023

What are the main principles of PPP? ›

PPP is based on two main principles: Both parties invest in the project. In a financial sense (manpower, materials budget) and in an expertise-related sense (knowledge, networks). The parties contribute to a societal and often also commercial purpose.

Why is PPP a good measure? ›

Advantages of PPP: A main one is that PPP exchange rates are relatively stable over time. By contrast, market rates are more volatile, and using them could produce quite large swings in aggregate measures of growth even when growth rates in individual countries are stable.

Why do we need the per capita part to measure growth? ›

Sustained economic growth increases average incomes and is strongly linked to poverty reduction. GDP per capita provides a basic measure of the value of output per person, which is an indirect indicator of per capita income. Growth in GDP and GDP per capita are considered broad measures of economic growth.

What are the main reasons for deviations from PPP? ›

3 Causes of deviations from PPP

Trade barriers, such as tariffs, quotas, and subsidies, can affect the relative prices of goods and services across countries. Additionally, non-tradable goods and services, such as housing and utilities, tend to have different prices in different countries.

Is PPP more important than nominal? ›

GDP Nominal may not accurately reflect the standard of living since it does not account for differences in price levels. GDP PPP is often used to compare the standard of living among countries by adjusting for differences in price levels.

References

Top Articles
Latest Posts
Recommended Articles
Article information

Author: Pres. Lawanda Wiegand

Last Updated:

Views: 5287

Rating: 4 / 5 (71 voted)

Reviews: 94% of readers found this page helpful

Author information

Name: Pres. Lawanda Wiegand

Birthday: 1993-01-10

Address: Suite 391 6963 Ullrich Shore, Bellefort, WI 01350-7893

Phone: +6806610432415

Job: Dynamic Manufacturing Assistant

Hobby: amateur radio, Taekwondo, Wood carving, Parkour, Skateboarding, Running, Rafting

Introduction: My name is Pres. Lawanda Wiegand, I am a inquisitive, helpful, glamorous, cheerful, open, clever, innocent person who loves writing and wants to share my knowledge and understanding with you.