Purchasing power parity measurements consider the amount of goods and services a person can buy in a country when calculating how much a currency is worth. An individual may earn less money in one country, and have the opportunity to purchase a larger house or more food, because other prices are also cheaper in that country. Purchasing power parity allows an individual to calculate the standard of living available in different countries.
Effective Exchange Rate
Purchase power parity allows an individual to determine the effective exchange rate for foreign currency. If a euro is worth 1.5 dollars, but the price of an item in euros is the same in Germany as it is in dollars in America, the official exchange rate is still 1.5 dollars per euro. The effective exchange rate is $1 per euro, since a person who earns 40,000 euros in Germany can buy the same number of consumer goods as a person who earns $40,000 in America.
Foreign Military Analysis
Purchasing power parity also allows analysts to determine the strength of a foreign military. The U.S. has a large military budget, and it also has a stronger currency than other nations. Another country, such as China, may spend less money to hire an individual soldier or purchase an additional tank or airplane. One country may be able to create a stronger military force while having a smaller military budget, because military expenses are lower in that country.
Purchasing power parity calculations assume that all income in a currency is spent in the country where the currency is used. The parity calculation assumes that an Indian who receives income in rupees will purchase all necessary items using rupees. Many nations rely on foreign imports to satisfy some consumer needs, requiring an importer to exchange currency for a foreign currency to make the purchase.
It is possible for a country to be more wealthy than a neighbor according to per capita income measurements and still have a lower standard of living when using purchasing power parity to calculate income. If a dollar is worth one Swiss franc, but Swiss grocery store prices in Swiss francs are higher than American grocery store prices quoted in U.S. dollars, a Swiss worker can earn more money than an American worker and still have a lower standard of living.
Purchasing power parity affects both education and training costs. An employer can hire a worker in a foreign country and pay a much lower wage, while providing the worker with a comparable standard of living as a worker in the employer's home country. Additional costs, such as university education for a worker, are also lower because of purchasing power parity.