Purchasing Power Parity (PPP)
Purchasing Power Parity (PPP) is an economic indicator to compare the standard of living between different countries, taking into account the Gross Domestic Product per capita in terms of the cost of living in each country.
When you want to compare the GDP of different countries, it is necessary to compare it in a common currency since each country measures its product in its local currency.
With this indicator, an appreciation or depreciation of a currency will not change the purchasing power parity of a country, since the inhabitants of that country receive their wages and make their purchases in the same currency.
The theory of "Purchasing Power Parity" states that the exchange rates between the various currencies must be in such a way as to allow a currency to have the same purchasing power in any part of the world.
If with 1,000 dollars you can buy a television in the United States, with those same 1,000 dollars you should also be able to buy in Spain, Japan, or East Timor. The law that guarantees that this is complied with is international arbitration, which it controls by monitoring international markets in search of "bargains." That is, situations in which a product is very cheap in one place and that later allows it to be sold more expensively and thus earn the difference in price.
If the purchasing power parity is not met, the arbitrageurs can carry out their buying and selling operations, and this same operation causes the exchange rate to move until the parity law is met again.
Normally, purchasing power parity is met, although there are products in which it is not. Like, for example, services. If a haircut is worth € 10 in one place, no matter how cheap it is, you cannot buy it and then sell it more expensively in the market. There is also the case of goods that can be marketed but their transportation cost is so high that it does not compensate for the profit that may result from it.
There are several practical ways to measure purchasing power across countries. For example, the Big Mac Index tries to compare the purchasing power of different countries based on what the McDonald's Big Mac hamburger costs in all the countries where it can be purchased
The index is used to compare the relative cost of living of the citizens of each country and to know if the local currencies are overvalued or undervalued in relation to the US dollar. Under the theory of purchasing power parity, the dollar must be able to buy the same amount of goods or services in all countries. When this principle is not fulfilled, we will find ourselves faced with overvalued or undervalued currencies.
But the index is not only used to compare living costs, but also to analyze the foreign trade situation of a country, since a weak currency facilitates exports, while a strong currency facilitates imports. This index should not be considered at face value, but as what it is, a reference index today.