What is Purchasing Power Parity (PPP) Actually Saying?
The concept of Purchasing Power Parity (PPP) is saying:
🔹 The value of a currency should be based on how much it can buy in different countries.
🔹 If the same product (or basket of goods) costs different amounts in two countries, we can calculate the "fair" exchange rate using those prices.
In simple terms, PPP exchange rate tells us how much money in one country is needed to buy the same goods as in another country.
Breaking It Down Simply:
Imagine you are in India and USA at the same time. You want to buy the same burger in both places.
- In India, the burger costs Rs. 35
- In USA, the burger costs $1
➝ If $1 buys 1 burger in the USA, how many rupees should buy the same burger in India?
➝ Clearly, Rs. 35 should be enough to buy the burger in India.
➝ So, the PPP exchange rate is $1 = Rs. 35.
Now, compare this with the Nominal Exchange Rate (NER). Suppose the market exchange rate is:
- $1 = Rs. 70
- This means that if you convert $1 to rupees, you will get Rs. 70 in India.
- But we just calculated that Rs. 35 is enough to buy the same thing in India!
Conclusion:The Indian rupee seems
undervalued because, in reality, Rs. 35 should be equal to $1 (based on purchasing power), but in the market, Rs. 70 is needed to get $1.
This means you can buy a lot more in India for the same amount of money compared to the US.
Extending the Idea to a Basket of Goods
- Instead of just one burger, imagine a basket of 100 goods (rice, milk, clothes, etc.).
- Suppose the total cost of the same basket in:
- India = Rs. 2000
- US = $100
- The PPP exchange rate is:
- This means that, in terms of what you can buy, $1 in the US is equivalent to Rs. 20 in India.
Key Takeaways
✅ PPP exchange rate is found by comparing prices of the same goods in two countries.
✅ If the actual (market) exchange rate is different from PPP, it suggests a currency is overvalued or undervalued.
✅ If inflation is higher in one country, its currency will lose value, and PPP will change over time.
✅ When NER = PPP, it means both currencies have the same purchasing power.
Real-World Example of Purchasing Power Parity (PPP)
Example 1:
Let’s take the Big Mac Index, which is an actual method used by The Economist to compare the PPP of different currencies using the price of a McDonald's Big Mac burger.
Step 1: Price of a Big Mac in Different Countries
A Big Mac (same size, same quality) costs:
Now, let’s calculate the PPP exchange rate:
So, according to PPP, $1 should be equal to ₹40 because ₹200 in India buys the same burger that $5 buys in the USA.
Step 2: Compare with the Actual Exchange Rate
Now, suppose the actual Nominal Exchange Rate (NER) in the forex market is:
$1 = ₹83 (as per the current exchange rate in 2024).
Step 3: What Does This Mean?
- According to PPP, ₹40 should be enough to buy what $1 buys in the US.
- But in reality, ₹83 is needed to get $1 in the market.
- This means that, in terms of purchasing power, the Indian rupee is undervalued.
What Does This Imply for You?
- If you are earning in dollars and spending in rupees (e.g., an American tourist in India), India seems cheaper because your $1 gets you ₹83, but based on actual purchasing power, it should only get you ₹40.
- If you are earning in rupees and traveling to the USA, the US feels expensive because, based on purchasing power, ₹40 should be enough to get $1 worth of goods, but the market exchange rate is ₹83 per $1.
Step 4: Impact of Inflation on PPP
- If inflation in India is higher than in the USA, the price of the Big Mac in India will increase, say, from ₹200 to ₹220.
- Now, the new PPP exchange rate would be:
- This shows that over time, if inflation is higher in India, the PPP exchange rate will also change, meaning the rupee loses purchasing power faster than the dollar.
Final Takeaway
✅ PPP exchange rate is a way to compare the "real value" of currencies based on what they can buy in each country.
✅ If the actual exchange rate is much higher or lower than the PPP rate, it means the currency is undervalued or overvalued.
✅ Higher inflation in one country leads to a weaker currency in the long run.
Example 2:
Real-World Example of Purchasing Power Parity (PPP) Using an iPhone
Let’s take the price of the latest iPhone 15 Pro (128GB) in different countries (as of 2024).
Step 1: Price of iPhone in Different Countries
| Country | iPhone 15 Pro Price | Currency | Price in USD (Approx.) |
|---|
| USA | $999 | USD | $999 |
| India | ₹1,34,900 | INR | $1620 |
| UK | £999 | GBP | $1250 |
Now, let’s calculate the PPP exchange rate for India and the USA.
Step 2: Calculating PPP Exchange Rate
According to PPP, the exchange rate should be:
So, based on the iPhone’s price, the PPP exchange rate should be $1 = ₹135.
Step 3: Compare with the Actual Exchange Rate
Now, let’s compare this with the market exchange rate (NER) (as of 2024):
- Actual Forex Rate (NER): $1 = ₹83
This means that:
- According to PPP, the rupee should be weaker (₹135 per $1).
- But the actual exchange rate is stronger (₹83 per $1).
- This suggests that, based on iPhone prices, the rupee is overvalued, or Apple is pricing iPhones much higher in India due to taxes, import duties, and profit margins.
- If the iPhone were priced only based on PPP, it should cost ₹83,000 instead of ₹1,35,000 in India.
Step 4: What This Means for Consumers
For Indians Buying an iPhone:
- Indians are paying ₹1,34,900 ($1620) for a product that costs only $999 in the USA.
- This means Indians are paying about 62% more than Americans for the same phone.
- This could be due to import duties, GST (tax), and Apple’s pricing strategy in India.
For Americans Buying an iPhone in India:
- If an American comes to India and tries to buy an iPhone using dollars, it will be more expensive.
- Even if they convert $999 to rupees (at the actual exchange rate of ₹83), they only get ₹82,917, which is not enough to buy the iPhone in India.
Step 5: What Affects PPP?
- Import taxes and duties: Apple adds extra costs in India, making the iPhone much more expensive.
- Cost of living and wages: India’s average wages are lower, so luxury products are priced differently.
- Inflation differences: If inflation in India is higher, the PPP rate will change over time.
Final Takeaways
✅ According to iPhone prices, $1 should be ₹135, but in reality, $1 is ₹83, meaning iPhones are much more expensive in India.
✅ PPP works best for common goods (like food), but for luxury items like iPhones, other factors like taxes and brand pricing affect the cost.
✅ This shows why some Indians buy iPhones from the US instead of India to save money.
