Purchasing Power Parity

Purchasing power parity calculates exchange rates in terms of how much goods a currency can buy. Here's how purchasing power parity works: Imagine two countries, Alphastan and Betastan, produce only widgets. A widget costs 1 alpha in Alphastan and 3 betas in Betastan. The current exchange rate is 1 alpha = 6 betas. Under purchasing power parity, the alpha is overvalued vis-à-vis the beta, because each alpha buys goods worth only 3 betas. Alphastanians conscious of purchasing power parity would rush to Betastan, get six betas for an alpha, buy two widgets (6 beta/3 beta per widget) per alpha, and rush home. Purchasing power parity would thus anticipate that the people in Alphastan would bid up the beta until an alpha bought only 3 beta. Since purchasing power parity computations require that the goods be the same in every country, the Economist magazine uses a McDonald's hamburger for its world index of purchasing power parity. While more sophisticated analyses use a bundle of goods to compute purchasing power parity, determining purchasing power parity for complex economies remains difficult.