Purchasing power parity

Purchasing power parity (PPP) is the exchange rate at which the goods in one
country cost the same as goods in another country.

A simple example of a measure purchasing power parity is the "Big Mac index"
popularised by The Economist magazine, which looks at the prices of burgers
in McDonald's restaurants in different countries. If for example a Big Mac
cost 4 US dollars in the US and 3 pounds in Britain, the purchasing power
parity exchange rate would be 3 pounds for 4 dollars.

The purchasing power parity exchange rate will be different depending on
what goods are chosen to make the comparison. Typically, the prices of many
goods would be looked at, weighted according to their importance in the
economy.

Purchasing power parity exchange rates are useful for comparing living
standards between countries. Actual exchange rates can give a very
misleading picture of living standards. For example, if the value of the
Mexican Peso falls by half compared to the dollar, the Gross Domestic
Product measured in dollars will also halve. However, this doesn't
necessarily mean that Mexicans are any poorer - if incomes and prices
measured in pesos stay the same, they will be no worse off assuming that
imported goods are not essential to the quality of life of individuals.
Measuring income in different countries using purchasing power parity
exchange rates helps to avoid this problem.

One issue with PPP is, however, that most sources do not state the actual
content of the PPP, which is statistically deceiving e.g. Countries at
Economist.

As measures of quality of life, PPP shares problems with GDP per capita,
because the GDP is a measure of the economic output of the whole economy,
and the average GDP does not perfectly correlate with the quality of life,
which moreover cannot be measured in T-Shirts and Big Macs.

For example the quality of homes, and schools, access to public services the
extent of pollution and protective consumer laws are hard to measure, and
generally not taken into account in defining the PPP. Thus the use of PPP
alone (or the per capita GDP alone) can be highly deceiving and should only
be used in relation with other economic indicators.

Another problem of the per capita income is that it does not take into
account inequalities in wealth distribution. For example the GDP/head for
Japan is about $40,000, whereas the PPP is estimated as $27,000. Conversely,
the per capita GDP of the US is about $27,500 (2002) whereas the PPP is
$36,000. This would give the impression that the quality of life is better
in US than it is in the Japan. In reality however the U.S. has poverty and
crime rates and slums which are unheard of in Japan.