Purchasing Power Parity

December 12, 2005

Vikram Sharma

Note on Purchasing Power Parity

When someone from a developed country is considering taking a job in a developing country, she may have to consider a number of factors and salary is one of them. Let us assume that the given person has two job offers, one in the United States with an annual salary of $60,000 and another in India with everything else the same but with an annual salary of Rs. 2000,000 (approximately equivalent1 to $43,375 based on nominal exchange rate). Let us assume, everything else which is important for the person is exactly the same in both jobs and the person intends to spend all the salary on lifestyle goods2. On a pure dollar face value comparison the job in the US is more attractive because the salary is roughly 40% higher. Will this comparison change if someone told the person that she can buy much higher quantities of lifestyle goods in India with $43,375 than $60,000 would buy in the United States? Or simply saying the purchasing power of equivalent amount of Indian rupees3 is higher than the purchasing power of a US Dollar, which may mean that $43,375 in India is worth more than $60,000 in the United States. The fact is, in order to compare two currencies the nominal exchange rate is not adequate, but one has to use a different exchange rate which takes into consideration the buying power of the local currency. The exchange rate which equalizes the purchasing power of different currencies, given the prices of goods and services in the countries concerned, is referred to as Purchasing Power Parity (PPP). The application of PPP is not limited to simply comparing the buying power of different currencies but has a number of other applications, for example it is used to compare the standard of living of two or more countries. It is a necessary tool for such comparison because comparing the GDP per capita using market exchange rates does not accurately measure differences in income and consumption. Market...