THE THEORY OF PURCHASING POWER PARITY {PPP}

THE THEORY OF PURCHASING POWER PARITY {PPP}

The method we use   to convert the value of output of currency in different countries  into a common Â

currency ,is an important aspect inÂ

determining how world economy is growing, how a country individually is important to the growth of the economy and the comparison of average richness among individuals in different countries example united states and China. Conversion of national GDPs into dollars at market exchange may not be a better way of   doing   that. This us   leads   to   a    much   better  method  called  purchasing power parity {PPP} which  accounts for prices difference.

The purchasing power parity   { PPP} states that after adjusting the exchange rateÂ

between two countries the prices of goods is supposed to be the same in both countries. Based on the idea of an economist { Bic Mac index in 1986} where the idea of price of McDonalds Big Mac burger is used  to explain a unique indicator called Big Mac index. This   used    to explain the wealth of a country as well as   the undervaluation or relative  over of   currenciesÂ

across the world. The PPP is aimed at establishing parity among commodities in different countries, example if the cost of a commodity is $2 and 40 sterling  respectively   then its  overvalued by 22%,Â

in comparison between USA and Canada . The   action of Canadian food shop owners  selling sterling and buying dollars to exploit the price arbitrageÂ

would lead to depreciation of the price of sterling and appreciation of the price of dollars ,hence restoring  parity in the market .Also if the price of goods is high in Canada compared to USA, the buyers inÂ

USA will prefer their goods hence shunning away goods from Canada which will lead to the Canadians sellers lowering their price to the same parity as USA .Also the Canadian gorvenment may decide decrease the value of sterling  to the  US dollars, that the USA buyers may not pay more for the goods in Canada. The big mac index is hence used to measure the PPP in an economy.

Just like use of GDP has  its  demerits ,  in countriesÂ

with poor status   conversion of GDP into dollars at market exchange rates significantly undermines the true size of its living standards and economy .Use of PPP has its  demerits., example   it does not put into consideration the idea that despite inputs of Bic mac , manufacturing of  Bic mac and distribution being uniform. The cost of store front, cost of  labour to staff the stores ,franchise additional cost and  the cost to acquire and import are different across countries .{ Pakkok and Pollard 2003} areÂ

uncertain if PPP does  apply in goods and baskets of goods for example transport costs where goods not found locally, will be imported leading increased    transport cost .This  hence  lead to increase in prices of goods imported compared to local goods. Another one  is taxes .where in countries  where sales taxes like value added tax are high, the commodities will definitely be sold at a higher price than where they are low.

In conclusion the Bic Mac index is a unique and standard way , that explains   how the  world economy is growing andÂ

the individual growth of economy of individual countries . the parity of commodities is maintained by use of the Bic MacÂ

index .Despite its efficiency compared to the measure of GDPS, it has demerits example not capturing the cost of store front ,labour  to staff stores and  not taking care of effects of sales taxes in  different countries as well as transport costs in different countries.

Chen, C. F., Shen, C. H., & Wang, C. A. A. (2007). Does PPP hold for Big Mac price or consumer price index? Evidence from panel cointegration. Economics Bulletin, 6(16), 1-15.

Lal, A., & Scollo, M. (2002). Big Mac index of cigarette affordability. Tobacco Control, 11(3), 280-282.

Parko and pollard {Burgernomics }. 2003