how to calcurate purchasing power parity and give example
Purchasing Power Parity (PPP) is a measure used to compare the relative value of two currencies by taking into account the different prices of goods and services in each country. The PPP exchange rate is the rate at which the currency of one country would need to be converted into the currency of another country to exactly buy the same quantity of goods and services.
To calculate PPP, you would typically follow these steps:
1. Determine the prices: Identify a basket of goods and services that are commonly consumed in both countries you want to compare. These items should be similar in quality and quantity.
2. Convert prices: Convert the prices of the basket of goods and services in each country to a common currency using the current exchange rate.
3. Calculate the PPP: Divide the price of the basket of goods and services in one country by the price of the same basket in the other country. This will give you the PPP exchange rate.
4. Compare to the actual exchange rate: Compare the PPP exchange rate to the actual exchange rate between the two currencies. If the PPP exchange rate is higher, it suggests that the currency is overvalued, while if it is lower, it suggests that the currency is undervalued.
Here's an example:
Let's consider two countries, Country A and Country B.
- In Country A, the price of the basket of goods and services is $100.
- In Country B, the price of the same basket of goods and services is 500 units of their local currency.
- The current exchange rate between the two countries is 1 unit of Country B currency = $0.10.
To calculate the PPP exchange rate:
PPP = (Price in Country B / Price in Country A) = (500 units / $100) = 5 units
The PPP exchange rate is determined to be 5 units of Country B currency = $1.
Now, if the actual exchange rate between the two currencies is 1 unit of Country B currency = $0.08, it indicates that the Country B currency is undervalued compared to the PPP exchange rate.