discussion and clarification of ppp

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 is unprocessed goods like food commodities. The more processed and expensive a product becomes, the more it drifts from the PPP exchange rate to the currency echange 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. So a company that wants to compete internationally doesn't gain much from a high PPP exchange rate. The price benefit will only come from largely unprocessed domestic products that it's in need of and can buy with the domestic currency (ie products that are priced in domestic currency) for a price below the average international price.

Difficulties with PPP comparisons

While using PPP exchange rates for comparison is an improvement over using actual 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. A PPP exchange rate varies depending on the choice of goods used for the index. Hence, it is possible to deliberately or accidentally bias a PPP exchange rate by the choice of a bundle. PPP could also have difficulty accounting for differences in quality between goods in one country and equivalent goods in another. Other reasons that reduce PPP accuracy are:-

Product diffrences
Barrier of trade e.g. Tariffs, sactions and duties
Transportation costs

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 quality 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. Thus, even a PPP-adjusted measure of GDP per capita must be used with caution, as it is only one component of quality of life. For example, in 2002, the GDP per capita for Japan was about US$40,000 and the PPP was estimated as $27,000, while in the US, GDP per capita was about $36,400 and the PPP was $35,400 (in reality, the PPP and Nominal numbers are per definition the same in the local currency of the GDP number for any particular time period). The US has higher crime rates and a greater extent of poverty and slums 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.

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: http://www.imf.org/external/pubs/ft/weo/2004/02/data/dbcoutm.cfm?SD=1980&ED=2005&R1=1&R2=1&CS=3&SS=2&OS=C&DD=0&OUT=1&C=111&S=NGDP_R-NGDP-NGDPD-NGDPRPC-NGDPPC-NGDPDPC-PPPWGT-PPPEX-PPPPC&CMP=0&x=59&y=15. 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.