Purchasing Power Parity: Weights Matter

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PPP (purchasing power parity) is "the rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods and services in each country."
Example: If a hamburger sells in London for £2 and in New York for $4, the implied PPP exchange rate is 1 pound = 2 U.S. dollars.
PPP comparisons underpin indices such as the "Big Mac" index and broader international price comparisons.

Market exchange rates: the rate prevailing in the foreign exchange market (end-of-period or period average).
PPP exchange rates: based on prices of a wide range of goods and services to reflect purchasing power across countries.
Use case differences:
- Market rates are the logical choice for financial flows (for example, current account balances).
- PPP rates are often used for aggregating real GDP and measures of overall well-being.

The ICP was established in 1968 by the United Nations and the University of Pennsylvania to facilitate price comparisons across countries.
For the 2003–06 round, participating countries (about 147) provided national average prices for 1,000 closely specified products.
Measurement issues:
- The ICP is a large statistical undertaking with price comparisons available only at infrequent intervals.
- Between survey dates, PPP rates must be estimated, introducing potential inaccuracies.
- The ICP does not cover all countries; data for missing countries must be estimated.

Advantages of PPP:
- PPP exchange rates are relatively stable over time compared with volatile market rates.
- PPP better accounts for nontraded goods and services, which tend to be cheaper in low-income countries, and thus better reflects consumer purchasing power and overall welfare across countries.
Drawbacks of PPP:
- Harder to measure than market-based rates.
- Infrequent surveys and methodological questions about earlier surveys can affect accuracy.
- Coverage gaps require estimation for missing countries.

For many emerging market and developing countries, the ratio of the market and PPP U.S. dollar exchange rate is between 2 and 4.
For advanced economies, market and PPP rates tend to be much closer.
Consequences of using PPP weights:
- Developing countries receive a much higher weight in aggregations using PPP exchange rates than when using market exchange rates.
- The weights of China and India in the world economy are far greater using PPP exchange rates than market-based weights.
- The choice of weights makes a big difference in calculations of global growth, but little difference to estimates of aggregate growth in advanced economies.
- The per capita income gap between the richest and poorest countries is modestly reduced under PPP exchange rates (although it remains exceptionally large).
- Some countries can move up or down the income scale depending on whether PPP or market exchange rates are used.

Tim Callen is a former Assistant Director in the IMF’s Communication Department.
Opinions expressed are those of the author and do not necessarily reflect IMF policy.

Source: F&D Magazine — "Purchasing Power Parity: Weights Matter".

Purchasing Power Parity: Weights Matter
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