Purchasing Power Parity (PPP): concept and significance in the global economy and the cryptocurrency market

Key Points

• Purchasing power parity compares the cost of a specific set of goods in different countries for a more accurate comparison of currencies and determination of their real purchasing power.

• PPP is a key tool for adjusting GDP figures and analyzing the economic well-being of various regions, allowing for a more accurate assessment of the standard of living of the population.

• In the context of the cryptocurrency market, purchasing power parity helps explain how the populations of countries with weakened national currencies use digital assets to preserve their purchasing power.

What is purchasing power parity?

Have you ever wondered why a product that costs 10 dollars in the USA can be significantly cheaper in other countries? This is where the concept of purchasing power parity (PPP) comes into play. It is an economic tool that allows comparing the real purchasing power of different currencies around the world.

Essentially, PPP shows how many goods and services can be purchased for a specific amount of money in different countries. Whether it's a cup of coffee in Brazil or sneakers in Germany, purchasing power parity allows for an objective comparison of prices between different economies and regions.

Theoretical Basis of Purchasing Power Parity

The theory of purchasing power parity is based on the "law of one price". According to this principle, in the absence of trade barriers, identical goods should cost the same in all countries after converting prices at the exchange rate.

Let's consider a situation: a new smartphone costs 500 dollars in the USA and 55,000 yen in Japan. According to the PPP theory, the exchange rate between these currencies should be 1 dollar to 110 yen to ensure equal purchasing power.

However, in the real world, factors such as taxes, transportation costs, and local demand can significantly affect the prices of the same goods in different regions. Therefore, economists analyze not individual goods but entire consumer baskets that include food, clothing, housing, and energy. By comparing the cost of such baskets, one can more accurately determine the relative strength of different currencies.

Practical significance of purchasing power parity

Purchasing power parity has important practical significance in the real world, especially when assessing the economic development of countries and the cost of living in them. When calculating gross domestic product (GDP), PPP is used to adjust for price differences between countries, allowing for a more objective view of the real incomes and expenditures of the population.

Let's consider the example of India: if we assess its GDP per capita at the ordinary exchange rate, it may seem very low. But when adjusted for PPP ( taking into account the lower cost of living ) the picture changes – the relative average income becomes more comparable to other countries, and we get a fuller understanding of the standard of living.

The International Monetary Fund (IMF) and the World Bank regularly use GDP adjusted for PPP to more accurately reflect the distribution of wealth on a global scale.

Comparison of Living Standards

One of the main applications of PPP is to compare living standards in different countries. By adjusting local prices, you can understand how comfortably the same salary can allow you to live in various regions. For example, $50,000 can provide a high standard of living in one country, but only meet basic needs in another.

Currency exchange rate forecasting

Exchange rates can fluctuate due to various factors, including politics and the state of stock markets, but in the long run, they tend to converge towards levels determined by purchasing power parity. Economists use this principle for long-term forecasting of currency dynamics.

Detection of economic manipulations

In some cases, governments may artificially adjust the official exchange rate of the national currency, presenting it as stronger than it actually is. In such situations, PPP becomes a useful tool for determining the real value of a country's currency.

Big Mac Index and Other Practical PPP Indicators

You have probably heard of the Big Mac Index – an interesting and visual method of illustrating the theory of purchasing power parity. This approach, developed by The Economist magazine, is based on a simple principle: since Big Macs are roughly the same in all countries, comparing their prices in different regions can quickly demonstrate the purchasing power of various currencies. If a Big Mac costs $5 in the USA and only $3 in India, it reflects the exchange rate of the currencies of the two countries.

Over the years, other similar comparisons have emerged, such as the iPad index or the KFC index. These tools use everyday goods to visually demonstrate the principles of purchasing power parity in real life.

Limitations and Challenges of the PPP Concept

Despite its usefulness, purchasing power parity has certain limitations. One common issue is related to product quality. The same good can have different quality in different countries, even if it looks the same externally, which affects the price and makes direct comparison difficult.

Another significant restriction concerns non-tradable goods. Some goods and services cannot participate in international trade, such as real estate or local services (beauty salons, electricity supply). Depending on local conditions, prices for these goods and services can vary significantly.

Inflation and the relevance of data also present challenges. The PPP theory assumes relative price stability over a certain period, but inflation can disrupt this assumption. The method of price comparison that is relevant today may become outdated in a few months.

PPP and the Cryptocurrency Market

Although purchasing power parity and the cryptocurrency market are not directly related, like traditional currency markets, PPP can help better understand how people in different countries perceive cryptocurrencies and interact with them.

Bitcoin and other digital assets are global, not tied to any specific country. However, in regions with weak national currencies ( according to PPP assessment ) the relative cost of purchasing cryptocurrency for the local population may be higher, making digital assets a potential tool for protection against the devaluation of the national currency. This trend is particularly noticeable in countries experiencing periods of hyperinflation.

In economies with unstable currency or high inflation rates, stablecoins can help people preserve their purchasing power, making them an important financial tool in certain regions. Of course, stablecoins also carry certain risks, and analyzing through the lens of PPP can help determine how advantageous it is to convert local currency into stablecoins under specific economic conditions.

Conclusion

Purchasing power parity is a powerful tool for understanding global prices, incomes, and economic development. Despite certain imperfections, this concept creates conditions for an objective comparison of the economic strength of different countries.

Regardless of whether you are an economist forecasting exchange rates, a company developing pricing strategies, or just a curious traveler wanting to understand why goods abroad are cheaper or more expensive, the theory of purchasing power parity can provide valuable insights and help make more informed decisions.