Purchasing power parity of currency: concept, principles of calculation

In international practice, to calculate the purchasing power parity of a currency, a “consumer basket” is used – a set of goods and services demanded by the buyer.

Forming a “basket”, analysts pay attention to several specific factors, including consumption patterns in different countries. In addition, it is necessary to choose prices on the basis of the same principles, and the quality of products from different manufacturers must be comparable. The calculations will be correct only if the listed requirements are met.

The “consumer basket” includes social services, consumer services and goods, construction financing and the purchase of all kinds of equipment. “Basket” has been in use since the 1970s; before that, the ratio of the purchasing power of monetary units depended on the value of gold – there was a so-called gold parity. Currently, the purchasing power parity of currencies is determined by the amount of goods that can be exchanged for a unit of currency.

The principle of currency parity

The exchange rate of currencies depends on the purchasing power of monetary units. The comparison of currencies takes place at the expense of the cost of the “consumer basket”, expressed in one or another national monetary unit. The currency ratio is the exchange rate used when converting monetary units. However, the exchange rate sometimes differs from the value of “consumer baskets”, and the difference becomes significant in some cases.

The change in the exchange rate is due to an increase or decrease in prices for goods from the “consumer basket”. This situation is observed in the free market, while deviation from the principles of free market trade leads to exchange rate deviations. With this in mind, the purchasing power parity of the currency is at the heart of the exchange rate, although it determines it only in part.

It is naive to believe that an increase in the cost of a commodity in one of the countries instantly entails changes in the exchange rate: in practice, the theory of the ratio of the purchasing power of monetary units ignores many factors.

Much better method of “consumer basket” has proven itself to assess the standard of living in the state. Based on the data received, the government or international organizations begin to develop social development programs.