Global Financing and Rate Mechanisms Paper
Purchasing Power Parity
Onofre Castañeda
University of Phoenix
Jose L. Hernandez
MGT/448: Global Business Strategies
May 06,2006
Purchasing power parity, or PPP, is a mechanism used to calculate an alternative exchange rate between the currencies of two countries. The PPP is an international measure of how much a currency can buy, since goods and services have different prices in some countries than in others.
PPP exchange rates are used to compare standards of living internationally. A country's GDP is originally tallied in its local currency, so any comparison between two countries requires a currency conversion. Comparing real exchange rates does not reflect price differences between companies, so they are considered unrealistic. However, the differences between PPP and real exchange rates can be significant. For example, GDP per capita in China is about US $1,400, while using PPP it is about US $6,200. At the other end of the spectrum, Japan has a nominal GDP per capita of about US $37,600, but its PPP figure is only US $31,400.
An information way of measuring the PPP between two currencies is the Big Mac index. The Economist newspaper introduced the Big Mac index in September 1986 as a humorous approach to help people understand purchasing power parity. The index also gave rise to the word Burgernomics.
In January 2004, The Economist introduced a sister to the Big Mac index: the Tall Latte index. While the idea is still the same, the Big Mac is replaced by a cup of Starbucks coffee. And it just so happens that the average price of a Starbucks tall latte in America is the same as the average price of a Big Mac, $2.80. By dividing the local currency price in each country b ...