Purchasing power parity: An overview
Purchasing Power Parity (PPP) is a technique used to determine the relative value of currencies, estimating the amount of adjustment needed on the exchange rate between countries for the exchange to be equivalent to (or on par with) each currency’s purchasing power.
An example of this measure for making prices equal – which underlies purchasing power parity – is the Big Mac Index, which compares the prices of a Big Mac burger in McDonalds restaurants in different countries.
The Big Mac Index is presumably useful as, although based on a single consumer product that may not be typical, it is a relatively standardised product that includes input costs from a wide range of sectors in the local economy, such as agricultural
commodities (beef, bread, lettuce, cheese), labour (blue and white collar), advertising, rent and real estate costs, transportation, among others.
The following table, based on data from The Economist’s January 2013 calculations, shows the under (-) and over (+) valuation of the local currency against the US dollar in percentages, according to the Big Mac Index. As an example calculation, the local price of a Big Mac in Hong Kong, when converted to US dollars at the market exchange rate, was $2.19 – or 50% of the local price for a Big Mac in the USA at $4.37.
Hence, the Hong Kong dollar was deemed to be 50% undervalued relative to the US dollar on the PPP basis.