The purchasing power parity (PPP) theory compares the average costs of goods and services between countries using exchange rates. PPPs are useful for inter-country comparisons of GDP in real terms and economic data expressed in national currencies. PPPs are calculated at the product group level by comparing consumption baskets, then aggregated to GDP levels using weights. PPP exchange rates are meant to converge with actual exchange rates over the long run, though various factors can cause short-term deviations. PPPs are useful for output and productivity comparisons, while market exchange rates are better for trade-related analyses.

1. Purchasing Power Parity

2. What are PPPs?The Purchasing power parity (PPP) is a theory of exchange rate determination and a way to compare the average costs of goods and services between countries For example: Price of Pen = 2 $ (U.S) Price of Pen = 90 Rs then, By PPP, 1$= 45 Rs

3. What are the major uses of PPPs?First step in inter-country comparisons in real terms of GDP To compare economic data between countries that is expressed in units of national currencyThis Can also be achieved using Exchange rate system through forces of demand and supplyX-rate by Demand and Supply MeritsX-rates are easily understood being determined by the demand for & the supply of currencies X-rates are easily observed, cover all countries, readily available(newspapers) & timely (daily rates)DemeritsX-rate converted GDPs are not consistent over timeExchange rates are affected by the relative prices of tradable goods and by factors such as interest rates, financial flows etc

6. PPP & X-rateDifference between PPP and X-rate indicates Prices of product is understated or overstatedDifference between PPP and X-rate do not Indicates particular currency is undervalued or overvalued

7. PPP and X-ratePPP useful when comparing output levels or productivity levels between countriesX-rate based comparisons are more appropriate in others For ex- if an analyst wanted to work out how much could be imported with the proceeds from a particular level of exports then it would be necessary to use exchange rates rather than PPPs.Ideally in long run X-rate converges to PPP rate

8. PPP Equilibrium Story

9. PPP and X-rate in Long RunMarket BasketRatioYear

11. GDP-purchasing power parity 2009 Country Ranks

12. How are PPPs calculated for GDP?Two stagesAt the product group level CB = P1Q1 + P2Q2 + P3Q3 + ... + PnQn PPP for Product group N between two country = (CB)country1/(CB)Country2 At the GDP or any aggregate levels X=[(PPP PG1)*W1 + ------- +(PPP PG N)*Wn] PPP GDP of two country = X country1/ X country2 Prices used in the calculation of PPPs are market Prices

13. Gerschenkron effect arises when aggregation methods that use either a reference price structure or a reference volume structure to compare countries.Country reports prices that are not representative of its consumption patternsSituations when biases arise in PPPs

14. Interest rate PairityThe relationship between the exchange rates and interest rates, is called Interest rate parity or covered interest arbitrageInterest rate parity (IRP) holds when the rate of return on one currency deposits is just equal to the expected rate of return on other currency deposits.

15. Covered interest rate ParityRisk of foreign exchange is covered by entering into forward contract