Purchasing Power Parity

Patryk Formela
March 31st, 2017

Table of contents

  1. What is PPP
  2. Types of GDP
  3. Poland vs Norway
  4. Conclusion

Definition of PPP

Purchasing Power Parity (PPP) is an economic theory that compares different countries' currencies through a market “basket of goods” approach.

This is how the relative version of PPP is calculated:

\[ S=\frac{P_1}{P_2} \]

where:

\( S \) - represents exchange rate of currency \( 1 \) to currency \( 2 \)

\( P_1 \) - represents the cost of good “x” in currency \( 1 \)

\( P_2 \) - represents the cost of good “x” in currency \( 2 \)

Comparable GDP

There are two main ways to measure GDP of different countries and compare them:

  • GDP at exchange rate,
  • GDP (PPP)

Example 1

If basket of consumer goods =(beer) costs $1 in Poland and $10 in Norway, then the purchasing power parity exchange rate is \[ 1:10 \]

How many beers? Example 2

In Poland

GDP per capita $15000 and cost of one beer $1

\( {\text{total beers}}= \frac{15000}{1} \)

\( 15000 \) beers

In Norway

GDP per capita $90000 and cost of one beer $10

\( {\text{total beers}}= \frac{90000}{10} \)

\( 9000 \) beers

Conclusion

  • GDP at exchange rate can be used to measure a country's economic power,

  • GDP (PPP) is used to measure the quality of life in a country,

  • Even if a country has a higher GDP per capita, that country's people may still live poorer if the cost of living is more expensive.