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Purchasing Power Parity (PPP)

Theme 5: Introduction to Macroeconomics

Topic: Key Economic Indicators and Performance of an Economy

Relevance: H1 and H2 Economics

Introduction:


Gross Domestic Product (GDP) is one of the key economic indicator used to measure and compare between countries. GDP is usually measured in United States Dollars (USD) when being compared over space at the international level. A more accurate indicator to compare between countries will be Gross Domestic Product (GDP) base on Purchasing Power Parity (PPP).

GDP is usually measured in United States Dollars (USD), but to obtain that information, different countries will first measure their nominal GDP in their domestic currencies. For example, Switzerland’s GDP will be measured in terms of Swiss Franc (CHF), Singapore in terms of Singapore Dollar (SGD) and Malaysia in terms of Malaysian Ringgit (MYR).



The nominal GDP in their respective domestic currencies will then be converted into USD base on the prevailing exchange rate. For example, below are the estimated prevailing exchange rate of 2017 of the various currencies:

· 1 CHF is worth 1 USD

· 1 SGD is worth 0.76 USD

· 1 MYR is worth 0.25 USD


While GDP and GDP per captia are commonly used as a measurement of the income, wealth or richness of a country, it does not take into account the relative general price level, cost of living and purchasing power of each US dollar in the various countries.


The purpose of basing GDP on Purchasing Power Parity (PPP) is so that each US dollar will now be able to purchase same amount of goods and services in the different countries.

Purchasing Power Parity (PPP) and McDonald’s Big Mac


The purchasing power parity (PPP) can be explained using "The Big Mac Index", an index published by The Economist. McDonald’s Big Mac is a good example to use as it can be found in about 100 countries around the world. We will try to briefly explain PPP using the example of a Big Mac.


Prices of the Big Mac in domestic currency in the selected countries are shown in Table 2 and we convert them into USD using the estimated exchange rate.


You will notice in Table 2 that after converting into USD, the prices of a Big Mac in different countries in terms of USD are different.

· United States of America ~ 5.00 USD

· Switzerland ~ 6.50 USD

· Singapore ~ 4.40 USD

· Malaysia ~ 2.00 USD

McDonald’s Big Mac in Switzerland is more expensive than in the United States of America while Singapore and Malaysia is cheaper, with Malaysia being the cheapest.

Purchasing Power


Let’s look at how many Big Mac can we purchase using US$10 in the different countries.

· In the United States of America, you can buy 2 units of Big Mac

· in Switzerland, 1.54 units of Big Mac

· In Singapore, 2.23 units of Big Mac and

· in Malaysia, 5 units of Big Mac


Now we can see that with the same amount of US Dollars, example 10 USD, a person can buy different amount of Big Mac in different countries. If we assume the variation in price of Big Mac is similar to the general basket of goods and services, we can conclude that with the same amount of US Dollars, you can only buy lesser amount of goods and services in Switzerland compared to the United States of America. However, you can buy more goods and services in Singapore compared to the United States of America and even more goods and services in Malaysia.


By basing GDP with purchasing power parity (PPP), every dollar will now be able to purchase the same amount of goods and services. To do that, Singapore and Malaysia‘s GDP value in terms of US Dollars should be increased while Switzerland’s GDP value should be decreased respectively to the United States of America.


Using our above example, converting nominal GDP to GDP base on PPP would meant that :

GDP base on PPP of Switzerland will decrease and will be 0.77 of its Nominal GDP

GDP base on PPP of Singapore will increase and will be 1.114 of its Nominal GDP

GDP base on PPP of Malaysia will increase and will be 2.5 of its Nominal GDP


Conclusion:


Our estimates of “Nominal GDP base on PPP” has a similar trend compared to data from

https://knoema.com/nwnfkne/world-gdp-ranking-2017-gdp-by-country-data-and-charts

The differences in actual basing value are due to the Big Mac not being a perfect representation of the general basket of goods and services as well as the relative cost of living and general price level in the selected economies.


While United States' GDP at current prices in 2017 (20,513 Billions USD) is higher than China (13,457 Billions USD), after taking PPP into consideration, however, as China cost of living and general price level is relative lower than United States, after taking purchasing power parity into consideration, United States' GDP base on PPP in 2017 (20,513 Billions USD) is lower than China (25,313 Billions USD)


The idea of purchasing power parity (PPP) can also be applied to GDP per capita to have a more accurate comparison of standard of living.


Note: The data used are simplified and rounded to make them easier to understand or work with. Source of GDP related information: https://knoema.com/nwnfkne/world-gdp-ranking-2018-gdp-by-country-data-and-charts

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