What is purchasing power parity? PPP in plain words

Purchasing power parity, or PPP, is the exchange rate at which one country's money would buy exactly the same goods and services as another's. If a basket of groceries costs $100 in the United States and 8,000 rupees in India, the PPP rate is 80 rupees to the dollar, whatever the currency market says. Economists use PPP rates to compare incomes and economies after allowing for differences in local prices.

In short

• Market exchange rates are set by trading in currencies; PPP rates are worked out from what things actually cost in each country.
• Haircuts, rent and restaurant meals are much cheaper in poorer countries, so their incomes buy more than market rates suggest.
• Measured at PPP, China's economy was larger than the United States' in 2021, and India's was the third largest, according to the World Bank.

What does purchasing power parity mean?

The idea starts from the law of one price: the same thing should cost the same everywhere, once you convert currencies, because otherwise traders could buy it where it is cheap and sell it where it is dear. The IMF's explainer by Tim Callen gives the simplest case: if a hamburger costs £2 in London and $4 in New York, the PPP rate is £1 to $2.

A PPP rate is not one hamburger but a whole basket of goods and services, priced in each country with care so that like is compared with like. The rate that makes the two baskets cost the same is that pair of currencies' purchasing power parity.

How does the Big Mac index work? A worked example

In 1986 The Economist magazine began publishing the Big Mac index, a light-hearted test of PPP using one product sold almost everywhere in nearly the same form. The numbers below are illustrative, chosen to make the steps clear, not the index's latest readings.

Step 1: find the price in each country. Say a Big Mac costs $5.00 in the United States and 400 yen in Japan.

Step 2: divide one price by the other to get the burger's PPP rate: 400 ÷ 5 = 80 yen per dollar. At that rate, the burger costs the same in both countries.

Step 3: compare with the market rate. Suppose the currency market gives 150 yen per dollar. Then the Japanese burger costs 400 ÷ 150 = $2.67 to an American visitor.

Step 4: read the gap. The Japanese burger is about 47% cheaper in dollars, so by this rough measure the yen looks undervalued against the dollar by 47%: the market rate (150) is far from the burger's PPP rate (80).

A big gap between the market rate and the PPP rate doesn't mean a currency will move to close it. Big Macs can't be shipped across oceans and resold, and their price includes local rent and wages. That is why the index is a teaching tool rather than a forecast.

Why aren't market exchange rates enough?

Market exchange rates are set by people trading currencies for trade, investment and speculation, and they swing with interest rates and moods. They mostly reflect goods and assets that cross borders. But much of what people buy never does: haircuts, housing, public transport, childcare. As the IMF article puts it, these nontraded goods and services "tend to be cheaper in low-income countries."

The reason is wages. A barber in Mumbai is paid far less than a barber in Boston, so the haircut costs less, even though the two do the same job. Factories in poorer countries can be close to rich-country productivity, so traded goods cost about the same, but services cannot, so overall prices are lower. Converting a poor country's income at market rates therefore understates how much it buys at home. Callen notes that for many emerging and developing economies, the market rate is two to four times the PPP rate.

How does PPP change GDP comparisons?

To compare GDP, the total value of what an economy produces, across countries, it has to be put in one currency. Using market rates and using PPP rates can tell different stories, as this example shows.

	Country A	Country B
GDP per person, local currency	250,000 pesos	$60,000
Market rate	100 pesos per $	—
GDP per person at market rates	$2,500	$60,000
Prices compared with Country B	40%	100%
PPP rate	40 pesos per $	—
GDP per person at PPP	$6,250	$60,000

At market rates, people in Country B look 24 times richer. At PPP, the gap is about 10 times: still very large, but a different picture of how people live.

The real numbers come from the International Comparison Program, a joint effort led by the World Bank that prices thousands of products across the world. Its latest round, for the year 2021, was published in May 2024. It found that global output that year was $152.4 trillion in PPP terms. According to the ICP 2021 results, China's GDP was $29 trillion at PPP, 18.9% of the world's, the United States' $24 trillion, 15.5%, and India's $11 trillion, 7.2%. At market exchange rates, the United States was still the larger economy, and the World Bank said market rates overstate the high-income countries' share of world output by 16 percentage points.

When should PPP be used, and when not?

PPP is the better yardstick for living standards: comparing incomes, poverty and how much people can buy. The World Bank's international poverty line is set in PPP dollars for this reason, and the IMF uses PPP weights when it adds up world economic growth, which gives fast-growing developing countries a larger weight.

Market rates are the better yardstick for anything that crosses a border: paying for imports, servicing foreign debt, buying oil, or measuring an economy's weight in global finance. A country can't pay its dollar debts in PPP dollars. That is part of why the US dollar's role in trade and finance, explored in why the dollar is the reserve currency, depends on market rates, not PPP.

Still argued

PPP figures are estimates, and economists argue about them. Pricing comparable baskets is hard: a flat in Lagos and one in London are not the same product, and quality differences are difficult to measure. Each new ICP round can revise countries' sizes noticeably, and in 2024 the National Statistical Society of China stressed that PPP results are not official statistics and cannot replace market exchange rates. Whether exchange rates drift back toward PPP over the long run is also debated: the evidence suggests they do partly, but slowly, over years.

What does PPP mean for the reader?

PPP explains why a salary that sounds small abroad can go a long way there, and why travel feels cheap in some countries and dear in others. It also changes the answer to questions such as which economy is the world's largest. Prices within a country shift over time with inflation; PPP is the same idea applied across borders at a single moment. Both are part of a basic question in economics: what money is actually worth in the things it can buy.

Check yourself

• Explain the difference between a market exchange rate and a PPP rate in two sentences.
• Why are haircuts cheaper in poorer countries, and what does that do to their GDP at PPP?
• Name one question PPP answers better than market rates, and one it answers worse.

Sources

• Purchasing Power Parity: Weights Matter — Tim Callen, IMF Finance and Development, 2018
• International Comparison Program — World Bank
• ICP 2021, size of economies — World Bank, 2024
• Big Mac Index — Wikipedia