Purchasing power parity (PPP) relates to a technique employed by economists to demonstrate comparisons between countries regarding purchasing power of national currencies. The effectiveness of this method is derived from the use of the long term equilibrum exchange rate as compared to a simple exchange rate.
Basically, purchasing power of a given sum of money relies on the cost of living, or in other words the general price level. Therefore, purchasing power parity is capable of evaluating how much currency is needed to purchase goods and services in each of the areas being compared.
In essence, the world is far from being a single market and the dynamics pertain to various factors such as transportation costs, regulations, and tarrifs applied to imports inflate their selling prices.
Additionally, production costs differ widely depending on the country and this is based on diverse issues. And these include the availability of natural resources or raw materials and they can be abundant in one place and lacking in others, variations in climate and also the cost of labor.
Hence, prices are normally very different from one place to another, and the PPP exchange rates are applied mainly in international comparisons of living standards. The international comparison of the Gross Domestic Product contributes to not only taking into account price variations between nations.
The differences between real exchange rates and PPP exchange rates can be substantial. For example, when a currency such as the South African rand is overvalued, its GDP per capita appears much much greater than that of America, unless measured in PPP, which reflects the reality.
Purchasing power parity is in some cases used as an indicator of undervaluation or overvaluation of a currency versus other currencies on the foreign exchange market. The absolute PPP refers to an exchange rate between two currencies and is ascertained by evaluating particular consumption trends in a country and assessing the price of the same in another country.
The PPP technique can assist in getting the better of some problems relating to exchange rates of currencies undergoing sudden and abrupt variations without any changes in economic conditions. Some countries administratively fix the rates of their currencies and this has the effect of manipulating statistics and international comparisons.
A fitting illustration for PPP comparisons involves taking account a basket of items valued at A$1,000 in Australia at an average monetary value of 900 euros in Netherlands, in that case the PPP exchange rate of the dollar against the euro will be 0 90.