✅Unlike the exchange rate that reflects the value of a currency on the market, the PPP emphasizes the intrinsic value to a consumer.
The purchasing power is defined by the capacity of purchase of goods and services that can be obtained from a specific income. This purchasing power is different in each country with the same income. Indeed, the cost of living is not the same everywhere. In this video for example, you will see that a country like e.g. Ukraine being richer than Denmark by GDP PPP, but what you need to take into account is that in developing countries prices tend to be cheaper because the land labor costs less, that also means that the cost of living is lower. That’s why e.g. Ukraine’s local currency goes farther when using it at home than using it in Denmark because the Danish Krone does not buy as much because of higher prices.
Absolute PPP = Reference Basket price in t in the domestic country / Reference Basket price in t in the foreign country
Example: a basket of products is valued at $ 500 in the US and have an average cost of 400 euros in France, so the PPP exchange rate of dollar against the euro is 0.80.
Another measure of the PPP seeks to measure changes in purchasing power between two countries. That is what is known as relative PPP so that is the variation of the purchasing Power Parity between two periods.
Relative PPP = (Reference Basket price in t in the foreign country – Reference Basket price in t-1 in the foreign country) / (Reference Basket price in t in the domestic country – Reference Basket price in t-1 in the domestic country)
Example: a basket of products is valued at $ 500 in the US and has an average cost of 400 euros in France in 2011. In 2010, the same basket had an average cost of $ 480 in the U.S. and 380 euros in France. Then the evolution of exchange rates in PPP of the dollar against the euro is (400/380) / (500/480) = 1.0105%
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