Purchasing power parity is a real value comparison between two currencies. In general, purchasing power parity calculations are used to gauge the spending power of macroeconomic indicators, such as GDP in real terms. But purchasing power parity may also be used to compare the spending power of two currencies against a basket of related goods, such as groceries. To calculate purchasing power parity, analysts use a ratio derived from the price of goods and compared to the prevailing foreign currency exchange rate.
Determine which two currencies you would like to compare for purchasing power parity. The formula for purchasing power parity requires two prices in different currencies to calculate the price ratio:
S (purchase power parity ratio) = Price 1/Price 2
In this case, P1 refers to one price in a specific currency, and P2 refers to another price in a different currency.
For instance, suppose you want to calculate the purchasing price parity between the United States and Mexico. Your comparison prices will be in U.S. dollars and Mexican pesos.
Determine which product is commonly available in both the United States and Mexico. For simplicity, we'll compare the price of Coca Cola in both countries. Although comparing one common product is one strategy, economic analysts may also select a group of common products to calculate a more broad measure of purchasing power parity. This group of products is commonly called a basket of goods and may include food staples such as bread, milk and other related items. Although the basket approach may be broader, the single item method helps illustrate the calculation in simpler terms.
Research the prices of Coca Cola in Mexico and the United States. The purchasing power parity formula requires you to know the price of the item you are comparing. Assume for this example that a 12-ounce can of Coca Cola costs $1.50 in U.S. dollars and $9 Mexican pesos. Divide the $9 pesos by $1.50. The result is the price ratio for purchasing power parity. To illustrate the calculation refer to the following:
S = P1/P2
S = 9/1.50
S = 6
Compare the result of the purchasing power parity to the currency exchange rate between the United States and Mexico. Assume that the exchange rate between the Mexican peso and U.S. dollar is 5.7 pesos for every dollar. Recall that for purchasing power parity to exist, the exchange rate and the purchasing power parity ratio must be equal. The purchasing power parity ratio of 6 and a $5.7 peso per dollar exchange rate between the currencies in Mexico and the United States indicates that the purchasing power of the peso and the dollar are similar but not exact. This means that Mexican and U.S. consumers have similar purchasing power with their respective currencies.
However, if the exchange rate between the dollar and the peso suddenly changed to $17 pesos per dollar and the purchasing power parity ratio remained at 6, the purchasing power parity calculation shows a loss of purchasing power for Mexican consumers relative to the U.S. consumers. ?