Let's Break It Down - Purchasing Power Parity

Introduction

Why does a burger cost $6 in the United States but much less in some other countries? And how can we compare incomes across countries with very different prices? Economists use a concept called purchasing power parity, or PPP, to answer these questions.

What Is Purchasing Power Parity?

Purchasing power parity is the idea that, over time, exchange rates should adjust so that the same basket of goods costs the same in different countries. If a basket costs $100 in the U.S. and 500 units of another currency abroad, the PPP exchange rate would be 5 to 1.

The Big Mac Index

The Economist magazine created a fun way to explain PPP called the Big Mac Index. It compares the price of a McDonald's Big Mac in different countries. If a Big Mac is much cheaper in one country after converting currencies, that suggests its currency may be undervalued compared to the dollar.

Why PPP Matters

Economists use PPP to compare living standards more accurately. A salary that seems low in dollars might go much further in a country where prices are lower. When measured by PPP, some economies, like China and India, look much larger than when measured using market exchange rates.

Conclusion

Purchasing power parity helps us understand what money is really worth around the world. Next time you travel abroad, you might notice PPP in action at the checkout counter!