GDP adjusted for Purchasing Power Parity (PPP) in the world, 2009 Purchasing Power Parity adjustment for the countries of the world as of 2003. The economy of the United States is used as a reference, so that country is set at 100. Bermuda has the highest index value, 154, thus goods sold there are more expensive than in the United States. Purchasing power parity (PPP) is a theory of long-term equilibrium exchange rates based on relative price levels of two countries. The idea originated with the School of Salamanca in the 16th century 1 and was developed in its modern form by Gustav Cassel in 1918.2 The concept is founded on the law of one price; the idea that in absence of transaction costs, identical goods will have the same price in different markets. In its "absolute" version, the purchasing power of different currencies is equalized for a given basket of goods. In the "relative" version, the difference in the rate of change in prices at home and abroad—the difference in the inflation rates—is equal to the percentage depreciation or appreciation of the exchange rate. Deviations from the theory imply differences in purchasing power of a "basket of goods" across countries, which means that for the purposes of many international comparisons, countries' GDPs or other national income statistics need to be "PPP adjusted" and converted into common units. The best-known and most-usedsays who? purchasing power adjustment is the Geary–Khamis dollar (the "international dollar").

Real exchange rate fluctuations are mostly due to different rates of inflation between the two economies.citation needed Aside from this volatility, consistent deviations of the market and purchasing power adjusted exchange rates can be observed, for example (market exchange rate) prices of non-traded goods and services are usually lower in countries with lower incomes (a U.S. dollar exchanged and spent in India will buy more haircuts than a dollar spent in the United States). There can be marked differences between purchasing power adjusted incomes and those converted via market exchange rates.3 For example, the World Bank's World Development Indicators 2005 estimated that in 2003, one Geary-Khamis dollar was equivalent to about 1.8 Chinese yuan by purchasing power parity4—considerably different from the nominal exchange rate. This discrepancy has large implications; for instance, when converted via the nominal exchange rates GDP per capita in India is about US$1,100 while on a PPP basis it is about US$3,000. This means that if calculated at nominal exchange rates, India has the eleventh largest economy, while at PPP-adjusted rates, it has the fourth largest economy in the world. At the other extreme, Denmark's nominal GDP per capita is around US$62,100, but its PPP figure is only US$37,304. Contents 1 PPP measurement 1.1 Big Mac Index 2 Need for PPP adjustments to GDP 3 Difficulties 3.1 Range and quality of goods 3.2 Additional Issues 3.3 2005 ICP 4 See also 5 Notes 6 External links // PPP measurement

The PPP exchange-rate calculation is controversial because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries. Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a uniform price level; rather, the difference in food prices may be greater than the difference in housing prices, while also less than the difference in entertainment prices. People in different countries typically consume different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a price index. This is a difficult task because purchasing patterns and even the goods available to purchase differ across countries. Thus, it is necessary to make adjustments for differences in the quality of goods and services. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared. When PPP comparisons are to be made over some interval of time, proper account needs to be made of inflationary effects. Big Mac Index Big Mac hamburgers, like this one from Japan, are similar worldwide. Main article: Big Mac Index An example of one measure of law of one price, which underlies purchasing power parity, is the Big Mac Index popularized by The Economist, which looks at the prices of a Big Mac burger in McDonald's restaurants in different countries. The Big Mac Index is presumably useful because it is based on a well-known good whose final price, easily tracked in many countries, includes input costs from a wide range of sectors in the local economy, such as agricultural commodities (beef, bread, lettuce, cheese), labor (blue and white collar), advertising, rent and real estate costs, transportation, etc. However, in some emerging economies, western fast food represents an expensive niche product price well above the price of traditional staples—i.e. the Big Mac is not a mainstream 'cheap' meal as it is in the west but a luxury import for the middle classes and foreigners. Need for PPP adjustments to GDP Gross domestic product (by purchasing power parity) in 2006

The exchange rate reflects transaction values for traded goods between countries in contrast to non-traded goods, that is, goods produced for home-country use. Also, currencies are traded for purposes other than trade in goods and services, e.g., to buy capital assets whose prices vary more than those of physical goods. Also, different interest rates, speculation, hedging or interventions by central banks can influence the foreign-exchange market. The PPP method is used as an alternative to correct for possible statistical bias. The Penn World Table is a widely cited source of PPP adjustments, and the so-called Penn effect reflects such a systematic bias in using exchange rates to outputs among countries. For example, if the value of the Mexican peso falls by half compared to the U.S. dollar, the Mexican Gross Domestic Product measured in dollars will also halve. However, this exchange rate results from international trade and financial markets. It does not necessarily mean that Mexicans are poorer by a half; if incomes and prices measured in pesos stay the same, they will be no worse off assuming that imported goods are not essential to the quality of life of individuals. Measuring income in different countries using PPP exchange rates helps to avoid this problem. PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments. Countries with strong government control of the economy sometimes enforce official exchange rates that make their own currency artificially strong. By contrast, the currency's black market exchange rate is artificially weak. In such cases a PPP exchange rate is likely the most realistic basis for economic comparison. Difficulties

The main reasons why different measures do not perfectly reflect standards of living are PPP numbers can vary with the specific basket of goods used, making it a rough estimate. Differences in quality of goods are hard to measure and thereby reflect in PPP. PPP calculations are often used to measure poverty rates. Range and quality of goods The goods that the currency has the "power" to purchase are a basket of goods of different types: Local, non-tradable goods and services (like electric power) that are produced and sold domestically. Tradable goods such as non-perishable commodities that can be sold on the international market (e.g. diamonds). The more a product falls into category 1 the further its price will be from the currency exchange rate. (Moving towards the PPP exchange rate.) Conversely, category 2 products tend to trade close to the currency exchange rate. (For more details of why, see: Penn effect). More processed and expensive products are likely to be tradable, falling into the second category, and drifting from the PPP exchange rate to the currency exchange rate. Even if the PPP "value" of the Ethiopian currency is three times stronger than the currency exchange rate, it won't buy three times as much of internationally traded goods like steel, cars and microchips, but non-traded goods like housing, services ("haircuts"), and domestically produced crops. The relative price differential between tradables and non-tradables from high-income to low-income countries is a consequence of the Balassa-Samuelson effect, and gives a big cost advantage to labour intensive production of tradable goods in low income countries (like Ethiopia), as against high income countries (like Switzerland). The corporate cost advantage is nothing more sophisticated than access to cheaper workers, but because the pay of those workers goes further in low-income countries than high, the relative pay differentials (inter-country) can be sustained for longer than would be the case otherwise. (This is another way of saying that the wage rate is based on average local productivity, and that this is below the per capita productivity that factories selling tradable goods to international markets can achieve.) An equivalent cost benefit comes from non-traded goods that can be sourced locally (nearer the PPP-exchange rate than the nominal exchange rate in which receipts are paid). These act as a cheaper factor of production than is available to factories in richer countries.

PPP calculations tend to overemphasise the primary sectoral contribution, and underemphasise the industrial and service sectoral contributions to the economy of a nation. Additional Issues In addition to methodological issues presented by the selection of a basket of goods, PPP estimates can also vary based on the statistical capacity of participating countries. The International Comparison Program, which PPP estimates are based off, require the disaggregation of national accounts into production, expenditure or (in some cases) income, and not all participating countries routinely disaggregate their data into such categories. Some aspects of PPP comparison are theoretically impossible or unclear. For example, there is no basis for comparison between the Ethiopian laborer who lives on teff with the Thai laborer who lives on rice, because teff is impossible to find in Thailand and vice versa, so the price of rice in Ethiopia or teff in Thailand cannot be determined. As a general rule, the more similar the price structure between countries, the more valid the PPP comparison. PPP levels will also vary based on the formula used to calculate price matrices. Different possible formulas include GEKS-Fisher, Geary-Khamis, IDB, and the superlative method. Each has advantages and disadvantages. Linking regions presents another methodological difficulty. In the 2005 ICP round, regions were compared by using a list of some 1,000 identical items for which a price could be found for 18 countries, selected so that at least two countries would be in each region. While this was superior to earlier "bridging" methods, which is not fully take into account differing quality between goods, it may serve to overstate the PPP basis of poorer countries, because the price indexing on which PPP is based will assign to poorer countries the greater weight of goods consumed in greater shares in richer countries. 2005 ICP

The 2005 ICP round resulted in large downward adjustments of PPP (or upward adjustments of price level) for several Asian countries, including China (-40%), India (-36%), Bangladesh (-42%) and the Philippines (-43%). Surjit Bhalla has argued that these adjustments are unrealistic. For example, in the case of China, backward extrapolation of 2005 ICP PPP based on Chinese annual growth rates would yield a 1952 PPP per capita of $153 1985 International dollars, but Pritchett has persuasively argued that $250 1985 dollars is the minimum required to sustain a population, or has ever been observed for more than a short period. Therefore, both the 2005 ICP PPP for China and China's growth rates cannot both be correct. Angus Maddison has calculated somewhat slower growth rates for China than official figures, but even under his calculations, the 1952 PPP per capita comes to only $229. Deaton Heston has suggested that the discrepancy can be explained by the fact that the 2005 ICP examined only urban prices, which overstate the national price level for Asian countries, and also the fact that Asian countries adjusted for productivity across noncomparable goods such as government services, whereas non-Asian countries did not make such an adjustment. Each of these two factors, according to him, would lead to an underestimation of GDP by PPP of about 12%. See also Business and economics portal Big Mac Index International dollar Relative Purchasing Power Parity List of cities by GDP List of countries by GDP (PPP) List of countries by GDP (PPP) per capita List of countries by future GDP (PPP) estimates List of countries by future GDP (PPP) per capita estimates Measures of national income and output Penn effect Karl Gustav Cassel Geary-Khamis dollar Notes ^ Alan M. Taylor y Mark P. Taylor (2004) "The Purchasing Power Parity Debate," NBER Working Paper No. 10607 (online). ^ Gustav Cassel, "Abnormal Deviations in International Exchanges," in Journal, (December, 1918), 413-415 ^ FT.com / World - China, India economies ‘40% smaller’:By Scheherazade Daneshkhu in London Published: December 18 2007 18:04 ^ 2005 World Development Indicators: Table 5.7 | Relative prices and exchange rates External links Penn World Table Explanations from the U. of British Columbia (also provides daily updated PPP charts) OECD Purchasing Power Parity estimates updated annually by the Organization for Economic Co-Operation and Development (OECD) World Bank International Comparison Project provides PPP estimates for a large number of countries UBS's "Prices and Earnings" Report 2006 Good report on purchasing power containing a Big Mac index as well as for staples such as bread and rice for 71 world cities. "Understanding PPPs and PPP based national accounts" provides an overview of methodological issues in calculating PPP and in designing the ICP under which the main PPP tables (Maddison, Penn World Tables, and World Bank WDI) are based