Union Budget 2019: Purchasing power parity helps compare economies in terms of cost of living

The Gross Domestic Product (GDP) is a popular metric to calculate the size of a country’s economy. The GDP, by definition, is the market value of all final goods and services from a nation in a given (financial) year. However, the GDP figures do not account for the apparent differences in the cost of living in every country. Hence, fluctuations in the exchange rates can push or pull a country’s GDP rankings every year without accounting for the changes in the standard of living.

Hence, the purchasing power parity (PPP) has become a preferred tool to compare economies based on their cost of living. Simply put, the purchasing power parity is equalising the purchasing power of two currencies by taking into account the cost of living and inflation differences.

 Union Budget 2019: Purchasing power parity helps compare economies in terms of cost of living

Representational image. AFP

Under this metric, economists compare the quantity of currency one needed to purchase a given unit of a good or common basket of goods and services. However, it is difficult to compare the GDP of India and the United States on market exchange rates as it does not take into consideration the differences in the cost of living. But adjusting the GDP figures with PPP help economists make a more valid comparison between economies. In fact, the gap between richer and poorer countries narrows when one accounts for the PPP.

The Economist, the London-based magazine, comes out with an interesting matrix called the Big Mac. The matrix gives an idea about the PPP of every country based on the prices of McDonald’s Big Mac burger. For instance, if a Big Mac in China costs 10.41 renminbi and $2.90 in the US, then — according to PPP — the exchange rate should be 3.59 for $1. However, if the renminbi is actually trading at 8.27 renminbi for $1, the Big Mac matrix would suggest that the renminbi is undervalued.

The PPP is calculated by the following formula: S= P1/P2. In the formula, S represents the exchange rate of currency 1 to currency 2, P1 represents the cost of good X in currency 1 and P2 represents the cost of good X in currency 2.

The World Bank releases a report every three years that compares various countries, in terms of the PPP and US dollars. Moreover, the International Monetary Fund (IMF) and Organisation for Economic Co-operation and Development (OECD) base their economic analysis and prescriptions based on the PPP metrics.
GDP according to PPP

While China ($27.4 trillion) is the largest economy in the world in terms of PPP, the United States ($21.4 trillion) comes a distant second. India is a distant third, with a GDP adjusted to PPP at $11.4 trillion.

However, in terms of nominal GDP, the United States is the largest economy in the world followed by China. Japan is the third largest economy while Germany and India occupy the fourth and fifth positions in the world.

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Updated Date: Jun 21, 2019 17:07:57 IST