Purchasing power parity

Also called: PPP · Topic: Balance of Payments and Exchange Rates · NCERT: Class 10, Ch 1 "Development"; Class 11, Ch 8 "Comparative Development Experiences of India and its Neighbours"; Class 12, Ch 6 "Open Economy Macroeconomics"

Meaning

Purchasing power parity (PPP) is the long-run theory that exchange rates move until the same good costs the same in every country. It assumes there are no tariffs (taxes on imports), no quotas (limits on how much can be imported) and no transport costs.

• Absolute PPP formula: e = P / P*
• e = the rupee price of one dollar.
• P = the Indian price level.
• P* = the foreign (US) price level.

PPP matters for two reasons. First, it explains why a country with higher inflation sees its currency lose value over time. Second, PPP conversion rates let us compare GDP and living standards across countries on a fair basis.

Explanation

How PPP works: the law of one price

• The law of one price is the idea behind PPP. If the same good is cheaper in one country, people buy it there.
• Demand for that country's currency rises.
• Its currency gains value (appreciates).

• Prices in the two countries come back into line.

• Main conclusion: in the long run, exchange rates reflect relative price levels. A country with higher inflation sees its currency depreciate (lose value).

• When PPP holds exactly, the real exchange rate (R = eP*/P, the price of foreign goods in terms of Indian goods) equals 1. When R moves away from 1, PPP is not holding.

Two versions: absolute and relative PPP

• Absolute PPP (the "level" version): e = P / P*.
• Relative PPP (the "change" version): % change in e ≈ Indian inflation − foreign inflation.
• Example: India has 6% inflation and the US has 2%. PPP then predicts the rupee falls about 4% a year against the dollar.

Worked example: the shirt (NCERT Class 12, Example 6.1)

• A shirt costs $8 in the US and ₹400 in India.

• PPP rate = 400 / 8 = ₹50/$.

• Suppose the market rate is ₹60/$:

• The US shirt costs 8 × 60 = ₹480. The Indian shirt costs ₹400.
• Buyers go to India, so demand for rupees rises.

• The rupee appreciates back towards ₹50/$.

• Suppose prices then change:

• Indian prices rise 20%, from ₹400 to ₹480.
• US prices rise 50%, from $8 to $12.
• New PPP rate = 480 / 12 = ₹40/$. The dollar depreciates because US inflation was higher.
• Check with relative PPP: 1.20 / 1.50 = 0.8, so e falls 20% (50 → 40).

Worked example: a projection (NCERT Q15)

• The rate is ₹30/$ in 2010. Indian prices double by 2030, and US prices stay flat.
• New rate = 30 × (2 / 1) = ₹60/$ in 2030.
• Lesson: if the Indian price level doubles, PPP says the rupee loses half its value.

Why PPP fails in the short run

• Many goods cannot be traded. Haircuts and housing cannot be shipped abroad, so their prices do not even out.
• Tariffs, quotas and transport costs exist in the real world.
• Capital flows and speculation (buying currency to profit from expected changes) move the rupee every day.
• So PPP shows a long-run tendency. It cannot predict tomorrow's rate.

Uses of PPP: the Big Mac index and GDP comparison

• Big Mac index (from The Economist): an informal PPP test using the price of one burger in different countries.
• Implied PPP rate = local burger price ÷ US burger price.
• If the implied rate is lower than the market rate, the local currency is undervalued.
• Example (made-up numbers): the burger costs ₹200 in India and $5 in the US. Implied rate = ₹40/$. The market rate is ₹85/$, so the rupee looks undervalued.

• Limitation: the burger price includes rent and wages, which cannot be traded. Poorer countries usually look "undervalued" because their labour is cheap.

• PPP conversion rates for GDP: these remove differences in price levels, so the same money buys the same basket of goods everywhere.

• Market exchange rates make poor countries look smaller than they really are.
  • Non-traded goods and services, such as haircuts and housing, are cheap in poor countries.
  • Market rates do not count this cheapness.
  • PPP rates do count it, so they show real output more accurately.

In India

• International Comparison Program (ICP): this is the global exercise that produces PPPs.
• It works under the UN Statistical Commission and is coordinated by the World Bank [2].
• The ICP 2021 round covered 176 economies. It was the tenth cycle since the ICP began in 1968 [2].

• The global economy in PPP terms was $152 trillion (2021) [2].

• India's position: India was the third-largest economy in PPP terms, at about $11 trillion, or 7.2% of the world total (ICP 2021) [3].

• It came after China and the US, and ahead of Russia, Japan, Germany, Brazil and France [3].

• NCERT also records India as third-largest in PPP terms.

• PPP and the rupee: India's inflation has usually been higher than US inflation. Relative PPP therefore explains why the rupee has tended to lose value against the dollar over the long run.

• The 1991 lesson: under the pegged and administered rupee, India's inflation stayed above its partners' for years.
• The nominal rate did not fall enough to match the inflation gap, so the rupee became overvalued in real terms. This was a departure from PPP.
• The trade deficit widened, and this fed into the 1991 BoP crisis (balance of payments crisis).
• The rupee was devalued in July 1991, and market-determined rates followed in 1993.

Don't confuse with

• Nominal exchange rate: the market price of a currency, for example ₹85 per $1. It moves every day. PPP is only the long-run level the rate tends towards.
• Real exchange rate (R = eP*/P): the price of foreign goods in terms of Indian goods. It is a measured value. PPP is the theory that says R should equal 1 in the long run.
• REER (real effective exchange rate): a trade-weighted, inflation-adjusted index of the rupee against a basket of currencies, published by the RBI. It measures competitiveness. It is not a PPP conversion rate used for GDP comparison.
• Market-rate GDP vs PPP-GDP: market-rate GDP converts output at the ₹/$ market rate. PPP-GDP converts it at PPP rates, so it shows real output and living standards. India ranks higher on PPP-GDP.

Prelims Hooks

• PPP assumes no tariffs, no quotas and no transport costs. It is a long-run theory, not a short-run predictor.
• Absolute PPP: e = P / P*. Relative PPP: % change in e ≈ home inflation − foreign inflation. The higher-inflation country's currency depreciates.
• When PPP holds exactly, the real exchange rate R = 1.
• The ICP, which produces PPPs, works under the UN Statistical Commission and is coordinated by the World Bank, not the IMF [2]. ICP 2021 covered 176 economies [2].
• ICP 2021: India was third-largest in PPP terms, at about $11 trillion (7.2% of world), after China and the US [3].
• Trap: on the Big Mac index, an implied rate lower than the market rate means the local currency is undervalued, not overvalued.

Mains Points

• PPP-GDP vs market-rate GDP:
• PPP-GDP (India third, 2021) [3] shows real output and living standards.
• Market-rate GDP decides global financial weight, debt capacity and voice in bodies that use quotas, such as IMF quotas.

• A good answer uses each measure for its proper purpose. PPP rank alone should not be used to claim economic power.

• Inflation and the rupee:

• Relative PPP shows that a lasting inflation gap with trading partners makes the rupee depreciate over time.

• Controlling inflation is therefore the lasting way to keep the rupee stable. RBI intervention can only smooth short-run swings.

• Limits of PPP in policy:

• Non-traded goods, trade barriers and capital flows keep market rates away from PPP for long periods.
• Policymakers therefore watch real measures such as the REER. The 1991 crisis showed the cost of letting the real rate drift away from PPP under a fixed peg.

Related concepts

• Big Mac index
• Real exchange rate
• Nominal Effective Exchange Rate
• Real Effective Exchange Rate
• Terms of trade
• Net barter terms of trade
• Income terms of trade
• Dutch disease

Read more

• The long run and real measures: PPP, real exchange rates, terms of trade