This page discusses problems with the notion of PPP (Purchasing power parity)

Range and quality of goods

The goods that the currency has the "power" to purchase are a basket of goods of different types:

1. Local, non-tradable goods and services (like electric power) that are produced and sold domestically.
2. Tradable goods such as non-perishable commodities that can be sold on the international market (e.g. diamonds).

The more a product falls into category 1 the further its price will be from the currency exchange rate. (Moving towards the PPP exchange rate.) Conversly, category 2 products tend to trade close to the currency exchange rate. (For more details of why, see: Penn effect).

More processed and expensive products are likely to be tradable , falling into the first category, and drifting from the PPP exchange rate to the currency exchange rate. Even if the PPP "value" of the chinese currency is five times stronger than the currency exchange rate, it won't buy five times as much of internationally traded goods, but non-traded goods like housing, services ("haircuts"), and domestically produced rice. The relative price differential between tradables and non-tradables from high-income to low-income countries is a consequence of the Balassa-Samuelson effect, and gives a big cost advantage to labour intensive production of tradable goods in low income countries (like China), as against high income countries (like Switzerland). The corporate cost advantage is nothing more sophisticated than access to cheaper workers, but because the pay of those workers goes further in low-income countries than high, the relative pay differentials (inter-country) can be surstained for longer than would be the case otherwise. (This is another way of saying that the wage rate is based on average local productivity, and that this is below the per capita productivity that factories selling tradable goods to international markets can achieve. This is sometimes called exploitation.) An equivalent cost benefit comes from non-traded goods that can be sourced locally (nearer the PPP-exchange rate than the nominal exchange rate in which receipts are paid). These act as a relatively cheaper factor of production than is available to factories in richer countries.

Difficulties with PPP comparisons in welfare economics

While using PPP exchange rates for income comparison is an improvement over using nominal (currency) exchange rates, it is still imperfect, and comparisons using the PPP method can still be misleading. Comparing standards of living using the PPP method implicitly assumes that the real value placed on goods is the same in different countries. In reality, what is considered a luxury in one culture could be considered a necessity in another. The PPP method does not account for this. (This is not primarily a flaw in the exchange rate methodology, as cultural and interpersonal differences in utility functions are a more fundamental microeconomic problem.)

A PPP exchange rate varies depending on the choice of goods used for the index (CPI). Hence, it is possible to deliberately or accidentally bias a PPP exchange rate by the choice of a bundle. Indeed, it may be hard to construct equivalent representative bundles for the consumption habits of very different societies. PPP could also have difficulty accounting for differences in quality between goods in one country and equivalent goods in another, see: consumer price index.

Even if a good PPP is used, GDP per capita is still a measure of the economic output of the whole economy, not a direct measure of the mean or median person's quality of life. Other factors such as the standards of homes and schools, access to public services, the extent of pollution, and strength of consumer protection laws are hard to quantify and generally not fully reflected in the GDP. Even a PPP-adjusted measure of GDP per capita must be used with caution, for all the usual reasons that the GDP figure itself is limited (for instance, its inability to capture the surplus between subjective value and payment price).

For example, in 2002, the nominal GDP per capita in Japan was about US$40,000, while the equivalent PPP into a US goods basket was estimated at $27,000. In the US, GDP per capita was about $36,400 (nominal and real if based on 2002 dollars). This means that the average US citizen could enjoy slightly more consumption than the average Japanese (vastly more if private saving is removed from consumption income). However, it does not necessarily follow, that this implies a "higher standard of living" in the sense of "enjoying life" more; the US has higher crime rates and less social cohesion than Japan, while Japan has much less physical space per person and arguably less individual freedom. Ultimately, the quality of life will depend on subjective judgement and individual preferences.

Per capital income also does not take into account inequalities in wealth distribution.

Difficulties with PPP in country comparisons

The ability of PPP-adjusted GDP to describe economy's ability to trade is limited by differences in:

• Infrastructure
• Barriers to trade; e.g. Tariffs, sanctions and duties
• Transportation costs
• The difference in the PPP exchange rate and the nominal (see: Penn effect.)

Clarification to PPP Numbers of the IMF

The GDP number for all reporting areas are one number in the reporting areas local currency. Therefore, in the local currency the PPP and market (or government) exchange rate is always 1.0 to its own currency, so the PPP and market exchange rate GDP number is always per definition the same for any duration of time, anytime, in that areas currency. The only time the PPP exhange rate and the market exhange rate can differ is when the GDP number is converted into another currency.

Only because of different base numbers (because of for example "current" or "constant" prices, or an annualized or averaged number) are the USD to USD PPP exchange rate not 1.0, see the IMF data here: [1]. The PPP exhange rate is 1.023 from 1980 to 2002, and the "constant" and "current" price is the same in 2000, because that's the base year for the "constant" (inflation adjusted) currency.

Clarification to PPP equalization

PPP equalization fails on many counts. The exchange rate only reflects traded goods in contrast to non-traded ones. Also, currencies are traded for purposes other than trade in goods and services, e.g. to buy capital assets whose prices vary more than those of physical goods. Also, speculation, hedging or interventions by central banks can influence the foreign exchange market.

See also

• Purchasing power parity