In macroeconomics, comparing economic data between different regions or countries is commonplace. But comparisons shouldn’t be made hastily. Naturally, goods and services are very often sold in different currencies that hold different values, so direct comparison often requires a currency conversion of some sort. And, the relative price level may differ between countries, such that making a direct comparison can be misleading.

For example, an economist might ask: is a Japanese car more expensive to purchase in Japan or in the United States? Since the currencies between the two countries differ, economists will have to calculate one currency in terms of the other in order to compare directly. One method for doing this is by using an exchange rate.

But currency exchange rates fluctuate very often, and are influenced by financial speculation as well as economic activity; so, the value of a Japanese car in terms of USD might change drastically from one day to the next. Thus, relying on exchange rates can be misleading for some applications, leading economists to search for alternative methods of comparison.

Purchasing Power Parity explained

Enter Purchasing Power Parity (PPP), which is used by economists as a way to directly compare the prices of goods in different countries more reliably and fairly. PPP is constructed as an exchange rate based on the total cost of a representative basket of goods and services in different countries (similar to how the CPI is constructed). An accurate PPP rate cannot be constructed by comparing only a single good.

However, once constructed, the PPP rate can be used to both compare the costs of specific goods and also give an indication of differences in the overall price level between countries. As such, PPP rates are used often by groups such as the International Monetary Fund, World Bank, the United Nations, and individual governments to answer macroeconomic questions.

PPP in its most simple form is constructed as a ratio of prices. For example, if the representative basket of goods costs $42,000 USD, and ¥3,906,000 (¥ is the symbol for Japanese yen), then the PPP rate between the US and Japan based on this consumer good is (42000 / 3906000) = 93.

This means that the same quality and quantity of goods takes roughly 93 times more currency to purchase in Japan than in the US, or that 1 USD in the United States can buy roughly the same amount of goods and services as ¥93 can in Japan.

Using PPP in this way, the costs of specific goods and services become directly comparable, and more accurately describe the true cost of living than market exchange rates. Exchange rates are partially determined by world news, financial speculation, and fluctuations in supply and demand for currencies – while PPP is a purely theoretical conversion, and is not traded or used in financial transactions.

Avoid common pitfalls when interpreting PPP

Interpreting PPP rates should be done with care. Note that even though our assumed PPP rate shows that 1 USD in the US can buy about the same as ¥93 in Japan, this does not mean that US residents are 93 times wealthier than residents of Japan. This does mean that, in order to compare prices between US markets and Japanese markets fairly, USD prices must be multiplied by 93 (or prices in yen could be divided by 93). But this does not state outright which country is wealthier or where residents are better off.

To see this, consider the following. One of the main differences between currencies is the magnitude of prices denoted in those currencies. Prices are set by market equilibrium (or occasionally by government decree), but the actual number is usually somewhat arbitrary in a measurement sense. To illustrate this concept, suppose that all prices in the economy doubled at the exact same time. What happens in such a scenario?

Most economists would agree that in this scenario, nothing happens. Since all prices doubled, the underlying logic of economic activity has remained completely unchanged. Therefore, behavior will not change at all. The term Monetary Neutrality explores a related idea, how the money supply – which influences prices – does not affect real economic variables. In this way, it should be clear that only real economic output and real economic variables affect the economy’s functioning.

Therefore prices themselves can be considered arbitrary measurements of economic value. They are simply numbers, and different societies around the world might choose to measure the same amount of economic value with a different number.

To put it another way, let’s return to our example between the US and Japan above. It’s possible that US residents earn on average, say, $25 USD per hour of work, while residents of Japan earn on average ¥2325 per hour of work. If this is true, workers in both countries are just as well off as each other in real terms. In this theoretical example, Yen prices in Japan are simply 93 times higher than US Dollar prices in the US, because the numbers used for the value of goods in Japan happen to be 93 times higher than those used in the US. (This is just an example; whether or not US workers make relatively as much as Japanese workers is not known from PPP alone).

Thus, PPP describes the relative price level in a region, but it does not describe the full picture of wealth or standards of living. To determine that, other information on average income, GDP per capita, inequality, costs of living, happiness, etc. are needed. Nevertheless, converting prices to a common currency using PPP rates is often a necessary and helpful first step in making macroeconomic comparisons.

Comparing actual PPP rates as of February 8, 2024

Finally, consider the following Table 1 as a demonstration of how PPP rates should be used and interpreted. The following PPP data was taken from the OECD’s “Monthly comparative price levels” table on February 8, 2024. Meanwhile, the GDP per capita column uses data taken from the World Bank’s “GDP per capita, PPP (current international $)” table on February 8, 2024.

Table 1: PPP rates comparison for select countries (converting to USD)

All currencies listed in Table 1 are converted to USD in the third column using PPP rates taken from the OECD. In the rest of this article, the phrase “PPP rate” is used to mean “PPP rate when converted to USD”. The OECD constructed this data by building a basket of goods worth 100 currency units in each country, and comparing the cost to a 100-currency-unit basket of goods in the other countries (we have divided their numbers in the third column by 100 to present it in terms of $1).

This table shows that in order to buy a basket of goods worth $1.00 USD in the United States, an individual must spend the equivalent of $0.81 USD in Germany, $1.10 USD in Ireland, $0.78 USD in Estonia, etc. to buy the same basket of goods. There are a few interesting results to discuss in the above table.

First, readers might notice that those three countries use the same currency, but have different PPP conversion rates! How can this be? Recall that PPP helps economists measure the relative price level of goods and services in each country. Although many countries in the European Union use the same currency, the relative price levels in each country can and do still differ – despite the value of the currency, the Euro, remaining the same.

To see this, consider that the same goods and services delivered in a major city might be more expensive than those same goods or services delivered in a rural village. A haircut in Paris is probably more expensive than a haircut in Colmar, France, which has a population of just over 70,000. Even though the same currency is being used, differences in economic activity in different areas can result in different price levels. So, even in cases where countries use the same currency, it’s a mistake to directly compare prices of the same good without taking the relative price level into account. PPP-converted rates must be used instead.

Another observation from Table 1: the PPP rate intended to compare price levels should not necessarily be taken as an indicator of a nation’s economic activity or GDP compared to another (there are, however, PPP rates at the GDP level, which are used in the fourth column – also see Further Reading below).

For example, the United States has one of the largest economies in the world. Because of this, casual observers might think that most other countries would have a PPP rate that is higher than 1, because if the US is such a rich and productive economy, people in other countries would need to make a lot of money to buy valuable American goods. But this is not true.

The PPP rate for Germany, 0.81, is similar to the PPP rate for Estonia, 0.78. Meanwhile, Denmark’s PPP rate is 1.4. But neither Germany nor Estonia is more productive overall than the US, despite having a lower PPP. And, Denmark is often rated one of the best places to live in the world – above the US – despite having a PPP rate above 1, and a lower GDP per capita than the US.

Also perhaps surprisingly, Ireland’s PPP-converted GDP per capita is much higher than the other countries in the table – and almost three times that of Japan! This might suggest that Irish residents are better off than Japanese residents, though other data is needed to paint a more complete picture.

Using these rates to compare relative standards of living can be useful, but this rate doesn’t say anything about – for example – how fairly wealth is distributed. The Gini Coefficient does this, and can be used in tandem to compare living standards for the average resident more in-depth.

In summary, then, it is critically important when making economic comparisons to find an appropriate PPP rate, and to understand exactly what that PPP rate can – and cannot – be used for. Most often, a PPP rate is used to directly compare the prices of specific goods or the standard of living between countries.

At INOMICS, we use PPP exchange rates to compare the salaries of economists on level terms in our annual Salary Report; if we did not, our comparisons of economist earnings around the world would be misleading – for example, unfairly overstating how much economists in North America earn.

Further Reading

With the exception of Table 1’s fourth column, this article has only considered PPP rates used for price comparisons for specific goods. However, PPP aggregates can be constructed in order to compare entire product groups, industries, and GDP.

The OECD has published a very helpful webpage about PPP, and has even produced a graphic that displays the proper use cases for PPP and pitfalls to avoid. For more information – and links to more technically detailed breakdowns of how PPP is calculated (aspiring macroeconomists, take note!) – visit the OECD’s page here.

Finally, numbeo.com is a good place for curious economists to have fun examining price data. The website tracks price and cost-of-living information across the entire world, and is partially supported by individuals reporting on prices in their local markets.

Good to Know

Economics students may be familiar with other indexes that are used to compare different regions for various topics. For example, economists might want to compare inflation levels using an index like the Consumer Price Index, or inequality using something like the Gini Coefficient.

But indexes can’t typically answer more specific questions that economists might want to study. Purchasing Power Parity – and sometimes exchange rates – are useful tools that can help provide an answer in such cases. There are many different tools to answer various economic questions, and often the most accurate indicator for one question might not be suitable for another!