Calculating Historical Purchasing Power Parity (PPP)

Have you ever looked at historical currency conversions and felt something was off? Comparing a 1980s income in Japanese Yen to US Dollars using only the market exchange rate of the time can paint a skewed picture of a person’s actual lifestyle and economic power.

This is where the concept of historical purchasing power parity (PPP) provides a much clearer lens. PPP is a fundamental economic tool that allows us to compare the value of currencies and living standards across different countries and time periods by focusing on what money can actually buy. It helps answer the question: how much money would be needed to purchase the same basket of goods and services in two different places?

What is Purchasing Power Parity (PPP)? A Core Concept Explained

At its core, Purchasing Power Parity (PPP) is a theoretical exchange rate that equalizes the buying power of different currencies. It eliminates the distortion caused by varying price levels between countries, making it an essential tool for comparing real income, GDP, and overall economic well-being on a global scale.

This powerful concept is used by major international organizations like the World Bank, the International Monetary Fund (IMF), and the OECD to create a more accurate and comparable set of global statistics.

Definition and the Law of One Price

PPP is an extension of a simpler economic principle known as the Law of One Price (LOP). The LOP states that, in an efficient market, an identical product should cost the same in any country once you account for the exchange rate.

PPP takes this idea and applies it to a broad basket of goods and services. There are two main versions:

• Absolute PPP: This is the pure form, arguing that the basket of goods itself should have the same price everywhere once currencies are converted.
• Relative PPP: This more flexible and widely accepted version focuses on how changes in inflation rates between countries will affect changes in the exchange rate over time.

A Simple Calculation Example

Understanding PPP is easier with a straightforward example. Imagine a specific basket of consumer goods and services costs $150 in the United States and £100 in the United Kingdom.

The PPP exchange rate would be calculated as: £100 / $150 = £0.67 per $1.

If the actual market exchange rate is £0.80 per $1, the pound is considered overvalued against the dollar according to PPP theory. You would need more dollars to buy a pound than what the relative purchasing power suggests.

A Brief History of Purchasing Power Parity

While a cornerstone of modern economics, the idea behind PPP has deep historical roots. It was developed and refined in response to major global economic shifts, particularly the disruptions caused by war and inflation.

Early Origins and Formalization

The core concept can be traced back to thinkers at the 16th-century Salamanca School in Spain, who explored relationships between prices and currency values. However, the theory was formally developed and named by Swedish economist Gustav Cassel in 1918.

Cassel proposed using PPP as a guide for countries looking to return to the gold standard after World War I. Wartime inflation had caused price levels to diverge dramatically, and he argued that exchange rates needed to be adjusted to reflect these new inflation differentials to restore economic balance.

Post-War Readjustments

The role of PPP became even more critical after both world wars. Cassel’s advice was that nations experiencing higher inflation should devalue their currencies to maintain parity. This principle provided a rational benchmark for setting new exchange rates when the old systems had broken down, helping to prevent severe economic misalignments.

Historically, PPP-based analysis has been crucial for identifying the need for currency realignments following extreme events like the hyperinflation in Germany in the 1920s or Zimbabwe in the 2000s.

How to Calculate Historical Purchasing Power Parity

Calculating PPP is not a simple back-of-the-envelope task. It is a massive statistical effort coordinated globally, most notably through the World Bank’s International Comparison Program (ICP). The process involves meticulous data collection and multi-stage aggregation.

Step 1: Comprehensive Price Surveys

The foundation of any PPP calculation is data. Statisticians survey the prices of thousands of carefully selected and specified products and services across participating countries. This basket is designed to be representative of total national spending, covering everything from food and clothing to healthcare and government services.

Step 2: Computing Price Relatives and Elementary PPPs

Once prices are collected, the next step is to compute price relatives for identical items. For example, the price of a specific brand of soda in Mexico is divided by the price of the same soda in the United States to get a price relative.

These individual relatives are then averaged (often using a geometric mean) within specific product groups to create what are called elementary PPPs. This gives a parity measure for narrow categories like “bread and cereals” or “footwear.”

Step 3: Aggregation Using Expenditure Weights

Finally, these elementary PPPs are weighted and aggregated into broader categories. The weights used are based on each category’s share of total national expenditure, derived from a country’s national accounts data.

This process continues up the chain—from product groups to consumption categories, and ultimately to a single PPP figure for the entire GDP. This ensures that items people spend more money on have a greater impact on the final PPP calculation. By understanding this, you can better appreciate the difference when using CPI to adjust historical values for domestic inflation versus using PPP for international comparisons.

PPP vs Market Exchange Rates: The Historical Divergence

One of the most important aspects of PPP vs market exchange rates is their differing behavior over time. While market rates are what you see on the news and use for international transactions, they often don’t reflect the true cost of living.

What Drives Market Exchange Rates?

Market (or nominal) exchange rates are notoriously volatile. They fluctuate daily based on a host of factors that have little to do with the price of goods, including:

• International capital flows
• Investor sentiment and speculation
• Central bank interest rate policies
• Political instability

These factors can cause a currency’s market value to deviate significantly from its PPP-implied value for long periods. You can see this volatility when tracking historical exchange rates over time.

Why PPP Provides a Long-Term Anchor

In contrast, PPP exchange rates are constructed to reflect a long-term equilibrium based on actual price levels. Economists like those at the St. Louis Fed note that while they diverge in the short term, market rates show a clear tendency to move in line with PPP-implied rates over the very long run.

For example, historical data for currencies like the US Dollar versus the Swiss Franc or British Pound show that while the spot rate can remain above or below the PPP rate for years, they often follow the same general long-term trend. This convergence is especially noticeable after major economic shocks like currency crises or periods of hyperinflation have passed.

Putting PPP into Practice: The Big Mac Index History

Perhaps the most famous and accessible illustration of PPP is The Economist magazine’s Big Mac Index. While informal and simplistic, the big mac index history provides an excellent real-world example of PPP in action.

The index compares the price of a McDonald’s Big Mac in various countries to its price in the United States. The Big Mac is used as the “basket of goods” because it is a standardized product made with similar local inputs (labor, rent, ingredients) in dozens of countries.

By comparing the local currency price to the US price, the index quickly reveals whether a currency is overvalued or undervalued relative to the US dollar. Historical data from the index consistently shows that many currencies remain misaligned from their PPP-implied value for years, highlighting the gap between market rates and real purchasing power.

Why Perfect Parity Is Rarely Achieved

If PPP is such a logical concept, why do market exchange rates deviate from it so often? Several real-world factors prevent prices from perfectly equalizing across borders.

• Non-Tradable Goods: Services like haircuts, housing, and local transportation cannot be easily traded between countries, so their prices can differ significantly.
• Barriers to Trade: Tariffs, quotas, and high transportation costs prevent perfect arbitrage, allowing price differences to persist.
• Taxes and Regulations: Different sales tax (VAT) rates and local regulations affect final consumer prices.
• Market Dynamics: As mentioned, speculation, government interventions, and other financial market forces can push exchange rates away from their PPP equilibrium for extended periods.

Frequently Asked Questions

What is purchasing power parity (PPP) and why is it important?

PPP is a theoretical exchange rate that equalizes the purchasing power of different currencies. It is important because it allows for more meaningful comparisons of income, GDP, and living standards across countries by removing the effect of different price levels.

How is PPP different from market exchange rates?

PPP is based on the long-term price levels of goods and services and is better for comparing real economic output. Market exchange rates are determined by short-term financial flows, speculation, and policy, and are used for daily trade and investment.

Why does PPP not always match actual exchange rates?

Market rates often diverge from PPP due to factors like non-tradable goods (e.g., local services), transportation costs, trade barriers like tariffs, and financial market speculation, which are not directly tied to the price of goods.

What is the Big Mac Index and how does it relate to PPP?

The Big Mac Index is an informal gauge of PPP created by The Economist. It compares the price of a McDonald’s Big Mac in different countries to illustrate whether currencies are overvalued or undervalued relative to their purchasing power.

Conclusion

Calculating historical purchasing power parity is a complex but essential process for anyone seeking to make accurate economic comparisons across time and borders. It cuts through the noise of volatile market exchange rates to reveal a clearer picture of a currency’s true value based on what it can buy.

While factors like trade barriers and non-tradable goods ensure that perfect parity is rarely achieved, PPP remains the gold standard for comparing national incomes and living standards. Understanding this concept is key to gaining a deeper insight into the historical purchasing power of money and the global economic landscape.