If you took a notebook and pen, and travelled the world, and you wrote down the prices of a pack of 6 locally produced eggs in every supermarket in the world, what would you discover? Apart from the fact that you may have had a lousy trip, you will realize how cheap it is to buy eggs in Bucharest (Romania) and how it is more expensive to by eggs in Dubai (UAE).
In a perfectly competitive world, all eggs everywhere would cost the same after factoring in the exchange rate. Same goes for Crude oil. Or for a Mattel toy car. Or for a Lego toy box. These should cost the same everywhere in the world. Except it is not the case.
The PPP theory states that, over a long period of time, the cost of similar goods in 2 countries would be the same if you converted the currencies at the prevailing exchange rates. However, this rarely happens.
Due to a host of reasons; transaction costs, government interventions, tariffs & duties, non-competitive prices or even sticky prices (wherein even with changing valuation of the currency or changing demand & supply for a product, the price of the good doesn’t change as it’s eventually cheaper to keep the same price) – the prices across countries for every day goods like eggs are not the same.
The famous Big Mac Index:
The big Mac index has been curated and tracked by The Economist since the 1980’s as an informal way to measure PPP. (Why the Big Mac burger – the burger is made in the exact same way in every country with the same ingredients and process which makes it a standard product useful to use for comparison)
The Big Mac PPP exchange rate between two countries is obtained by dividing the price of a Big Mac in one country (in its currency) by the price of a Big Mac in another country (in its currency). This value is then compared with the prevailing exchange rate - and then this helps to determine if the actual currency is under or over valued versus the other currency basis the current exchange rate.
Consider the example of Pound and USD:
Consider a second example - A more relevant one:
PPP changes every year – as the prices of goods & services keeps changing due to inflation, change in production costs, demand – supply ratios as well as other reasons.
Why do you need to consider PPP before saying yes to that swanky new job outside your country?
From the above example, we can see that while NOMINAL exchange rate for one dollar is 70 rupees, the actual rate is 20 rupees. Hence if you were offered a salary of 1 Lakh USD versus your current Indian salary of 42 lakhs - what would you consider more attractive? 70 lakhs INR (1 lakh USD converted to INR using current exchange rate) seemed like a no brainer – live the American dream while also most likely save more. But she was smarter than that.
Well, in India, you could purchase 42 lakh worth of products; in USA, however, the equivalent value you would be purchase is 20 lakhs (1 Lakh USD * 20 Rupees per dollar) – hence leading a more lavish life in India versus USA in terms of how much you could possibly buy.
Tying this example with our Big Mac graph, you can also see that in India, the sandwich would cost you around 2.5 USD but in the USA, the same sandwich would cost you 5.5 USD – more than twice. While the Big Mac index is only an informal and light hearted guide, it suffices to say that to maintain a similar standard of living in USA, she would have to spend twice as much as in India.
If you did want to work a few years abroad and then return back to India, you would get a huge conversion benefit of 70 rupees for every dollar saved! (so do consider that)
PPP or Purchasing Power Parity is an important macro-economic indicator which measures the relation between two currencies. Apart from the economy, it is also an important & useful factor when you have offices in almost every continent, when flights now connect you to almost every corner of the world and when most brands are now omnipresent – whether in Bulgaria or Uruguay. Understanding this concept and seeing where this applies in your own life will empower you to make better decisions – like in my friends case – where she leveraged her knowledge and negotiated for a higher salary.