In this case, the US can buy more goods and services from China, because its exchange rate is stronger than what the PPP would dictate. However, if the market exchange rate is higher than the PPP, for instance, 25:1 – it would mean that the US dollar is stronger than the Chinese Yuan as it can buy more of its currency. So if you earnt $5 in the US, you could exchange it and buy the same number of goods in China. In this case, it would equal 100 million Chinese Yuan divide by 5 million US dollars – which equals 20 Chinese Yuan to the US dollar.Īt this rate, PPP is achieved as both nations can buy the same number of goods and services at this exchange rate. To calculate the PPP, we would divide the total Yuan by the total US dollars. The total value of these goods may cost 100 million Yuan in China, but only 5 million US dollars in America. It then calculates the price of these, thereby working out the total cost of these goods in local currency.
Purchasing Power Parity (PPP) takes a basket of commonly purchased goods such as milk, televisions, motor vehicles, and phones, among others. However, it does provide a reasonable indication on the true value between currencies. Yet whilst the Big Mac provides a rough indication of the PPP between two countries, it is not necessarily accurate for the very reason that it only considers one good. At the same time, it is much easier to compare one item than a basket of thousands of goods. The Big Mac Index is a useful example as it is one of few items that is very similar in quality, but also, widely available across the world. At the same time, the actual exchange rate was 0.79 – which suggest the British Pound is undervalued by over 25 percent. This is calculated by dividing the price in Britain (£3.39), by the price in the US ($5.71). Named ‘ The Big Mac Index’, it simply works out the price of a Big Mac in Country A and Country B, and calculates the PPP between the two countries.įor example, the 2020 index shows that a Big Mac costs £3.39 in Britain and US$5.71 in the United States – which shows a PPP exchange rate of 0.59. The newspaper ‘The Economist’ created a simple example of the Purchasing Power Parity Index. So how much of Currency A is needed to buy exactly the same quantity of goods with Currency B. The PPP is then calculated by converting the value in one currency, to the value in the other. In its very basic form, Purchasing Power Parity (PPP) calculates the average basket of goods in one country and compares to another in that local currency. For example, you get less for your money in California than you do in Alabama. And third of all, it ignores regional differences. Second of all, there are no trade barriers that would enhance the price of the basket of goods.
In other words, it doesn’t cost businesses significantly more to ship or manufacture goods. First of all, there are no transaction costs. There are three main assumptions which define Purchasing Power Parity (PPP). Using Purchasing Power Parity (PPP) allows us to compare living standards of countries.
Anything above or below this would suggest the currency is over or undervalued.
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