Purchasing power parity

Purchasing power parity is the exchange rate at which the goods in one country cost the same as goods in another country.

A simple example of a measure purchasing power parity is the "Big Mac index" popularised by The Economist magazine, which looks at the prices of burgers in McDonald's restaurants in different countries. If for example a Big Mac cost 4 US dollars in the US and 3 pounds in Britain, the purchasing power parity exchange rate would be 3 pounds for 4 dollars.

The purchasing power parity exchange rate will be different depending on what goods are chosen to make the comparison. Typically, the prices of many goods would be looked at, weighted according to their importance in the economy.

Purchasing power parity exchange rates are useful for comparing living standards between countries. Actual exchange rates can give a very misleading picture of living standards. For example, if the value of the Mexican Peso falls by half compared to the dollar, the Gross Domestic Product measured in dollars will also halve. However, this doesn't necessarily mean that Mexicans are any poorer - if incomes and prices measured in pesos stay the same, they will be no worse off. Measuring income in different countries using purchasing power parity exchange rates helps to avoid this problem.