Academic journal article Monthly Labor Review

International Price Comparisons Based on Purchasing Power Parity

Academic journal article Monthly Labor Review

International Price Comparisons Based on Purchasing Power Parity

Article excerpt

Because exchange rate movements, in general, tend to be more volatile than changes in national price levels, the purchasing power parity approach provides the proper basis for comparing living standards and examining productivity levels over time

Imagine you are planning a trip to France and would like to figure out how much currency you will need during your visit. You would need to know how much in French francs it would cost for incidentals such as meals, sightseeing, and souvenirs. What information would be helpful to you in making your estimate? You could check the price of, say, a lunch in your hometown and then convert that figure into francs using the exchange rate. This type of estimate would not be very accurate, however, because it is likely that a lunch in your hometown costs relatively more or less than a lunch in France. A better estimate would be based on the price of a lunch in France.

Similarly, if you were opening a subsidiary company in Japan, how would you determine the salaries for your employees? Again, using the exchange rate to convert the salary you would pay in the United States into yen would not be accurate. To adequately compensate employees moving overseas, you would need information about the cost of living in Japan.

Finally, if a government or international organization were comparing national expenditures across different countries, merely collecting the gross domestic products (GDPs) of the countries and using exchange rates to convert them into a single currency would not yield an accurate comparison. Again, the comparison based on exchange rates does not take into account differing prices among the countries.

In each of these scenarios, analysts could construct better estimates if they convert the data into a common currency and value it at the same price levels. In September 1998, the Organisation for Economic Co-operation and Development (OECD) released price level data and measures for 1996 as a part of the Eurostat-OECD purchasing power parity (PPP) program. (Eurostat is the statistical office of the European Union.) The purpose of this program is to compare economic data across countries without using exchange rates. As illustrated in the previous scenarios, exchange rates do not necessarily reflect the relative purchasing powers of the different currencies and applying them can produce inaccurate comparisons. To accurately compare GDP data across countries, one must express the data in a common currency and value it at the same price level. These problems are similar to those encountered in comparisons of GDP across time for one country. Of course in the case of comparison across time, the data are already expressed in one national currency, but the figures must accommodate changes in the price level for the comparisons to have any meaning. Purchasing power parities are estimates derived from the relative price levels in different countries and reflect the rate at which currencies can be converted to purchase equivalent goods and services. Therefore, a PPP is the rate of currency conversion that equalizes purchasing power of different currencies and so has the dimensions of an exchange rate as well as a price index. PPPS are preferable to exchange rates for converting national expenditure data into a common currency because they also adjust for differences in price levels and reflect only differences in the volume of goods and services purchased between countries.

International organizations involved with multilateral comparisons of real GDP and its components increasingly base such comparisons on PPPS.(1) The European Commission also uses PPPS to determine funding levels, as well as to adjust staff salaries. Moreover, two recent reports analyzed the strengths and weaknesses of the PPP programs.(2) Independently, both came to the same conclusion, reaffirming the importance of using PPPs for real multilateral comparisons of GDP and related aggregates. …

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