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What is Purchasing Power Parity

Source: Questions and Answers on Basic Statistical Knowledge for Leading Cadres
Release Date: 2023-01-01

Making cross-national comparisons using economic indicators is an important method to measure the economic growth performance of economies and evaluate their stages of development. This requires converting the currency of each economy into a single common currency. Typically, people use official exchange rates to convert the currency of each economy into a single currency. However, some economists argue that exchange rates are highly susceptible to international capital flows and macroeconomic fluctuations. They only reflect the price ratio of tradable goods across different economies, failing to eliminate differences in price levels between them. Consequently, using exchange rates for international comparisons to some extent distorts the comparison results. To overcome the drawbacks of using the exchange rate as a currency conversion factor, economists developed the indicator known as "Purchasing Power Parity (PPP)".

I. Basic Concepts and Functions

Similar to exchange rates, PPP is a currency ratio that reflects the exchange of the same basket of goods and services between economies. Taking a single commodity, the Big Mac burger, as an example: its selling price in China is 23 RMB and in the United States is 5 USD. Using the United States as the base, the PPP for the Big Mac is 23/5 = 4.6.

Just like exchange rates, PPP can be used to convert economic indicators of different economies into a single currency unit. For instance, China's GDP in 2017 was 82,075.4 billion RMB. Converted at the year's exchange rate of 6.76, the GDP (exchange rate-based GDP) was 12,141.3 billion USD. Converted at the year's PPP of 4.18, the GDP (PPP-based GDP) was 19,635.3 billion USD.

Unlike exchange rates, PPP is an artificially constructed currency conversion factor. Therefore, although it avoids many defects of exchange rates, its accuracy is heavily influenced by source data, statistical measurement theory, and technical methodology. There are many projects that construct and produce PPP, and the most influential one at present is the International Comparison Program (ICP), led by the United Nations and the World Bank. Since 2017, the ICP has been organized and implemented approximately every three years, and the PPP estimation methods may vary across different rounds. Once the results of a new round are released, the estimation results of previous rounds must be revised accordingly.

II. Methodology for Estimating PPP in the ICP

Estimating PPP requires two sets of data. The first set of data comes from national accounts. Economies participating in the ICP need to break down their expenditure-based GDP, expressed in national currency, into 155 detailed items (known as basic headings). The sum of expenditures across these basic headings must equal the GDP. The second set of data comes from price surveys. Under each basic heading, there are several representative products with specific specifications. Each economy is required to survey the annual average prices of these items, expressed in national currency, according to a predetermined product list.

The basic approach to calculating PPP is to first compute the PPPs for the 155 basic headings using the price data of the specified products. Then, using the basic heading expenditures from the national accounts as weights, these PPPs are aggregated upward to obtain the PPPs for broader categories (namely, groups, classes, divisions, major aggregates, and GDP). The commonly cited figure of 4.18 for China's PPP in 2017 refers specifically to the PPP at the GDP level for China in 2017.

In the ICP, the estimation of PPP is conducted in two stages. In the first stage, participating economies submit their price and expenditure data to regional agencies, which are responsible for estimating regional results. In the second stage, the regional agencies submit the data to the World Bank, and the World Bank's ICP Global Office calculates the final global results by integrating the regional outcomes.

III. The 2017 PPP Results and Their Applications

The final results of the 2017 round of the ICP show (see Table 1) that China's PPP in 2017 was 4.18. This means that 4.18 RMB is equivalent to 1 USD, which was lower than the exchange rate of 6.76 for that year. Globally, the gap between PPP and exchange rates is larger for developing economies and smaller for developed economies. For most economies, the PPP value is lower than the exchange rate value, and only for a few economies is the PPP value higher than the exchange rate value.

Table 1 PPP and Exchange Rate Values for Selected Economies in 2017

Economy	PPP (USD = 1)	Exchange Rate (USD = 1)	PPP/Exchange Rate (%)
China	4.18	6.76	61.9
Indonesia	4695.66	13380.87	35.1
Japan	105.38	112.17	93.9
France	0.77	0.89	86.6
Germany	0.74	0.89	83.7
Italy	0.69	0.89	77.6
Russia	24.05	58.34	41.2
United Kingdom	0.68	0.78	87.9
Brazil	2.18	3.19	68.4
United States	1.00	1.00	100.0
India	20.65	65.12	31.7
South Africa	6.43	13.33	48.2

Note: Exchange rates for all economies are from the World Bank.

According to the 2017 PPP results, China's GDP in 2017 was 19.6 trillion USD, ranking 1st in the world (among 176 economies), which is one place higher than its ranking by exchange rate-based GDP. China's GDP accounted for 16.4% of the global economic total. Its GDP per capita was 14,150 USD, equivalent to 85.3% of the world average, ranking 90th globally, which is 11 places lower than its ranking by exchange rate-based GDP per capita. Its price level index was 92.8%, which was 7.2% lower than the global average price level.

The total economic size of the 176 economies combined was 119.5 trillion USD, 50.0% higher than the exchange rate-based total of 79.7 trillion USD. The global average GDP per capita was 16,596 USD, with the highest being Luxembourg at 112,701 USD, and the lowest being Burundi at only 784 USD. The economy with the highest price level in the world was Bermuda, with its price level at 204.9% of the global average, while the economy with the lowest price level was Egypt, at only 27.5% of the global average.