Why it is worth understanding purchasing power parity – from everyday expenses to investments in cryptocurrencies

What You Need to Know to Get Started

Have you noticed that 100 złoty has a different value in different countries? It's no coincidence – it's actually purchasing power parity (PSN), which explains why the same item costs this much in the USA, but differently in India or Poland. Understanding this mechanism is key to analyzing the global economy, comparing incomes between countries, and even making decisions about financial investments.

How does PSN work in practice?

At the beginning, one thing needs to be explained: the law of one price. Theoretically, the same product should cost the same everywhere in the world – taking into account the exchange rate. If a new phone costs 500 USD in the United States and 55 thousand yen in Japan, the rate should be 110 yen per dollar.

But the reality is more complicated. Taxes, transportation costs, local demand – all of this causes prices to vary. That’s why economists don’t look at individual products, but rather at entire baskets of goods – that is, sets of items that people typically buy: food, clothing, housing, energy. By comparing the prices of these baskets in different countries, one can determine the actual value of a currency.

PSN and GDP – what connects these two concepts?

Here, a key connection between GDP and GNI emerges. When we talk about the gross domestic product (GDP) of a country, we often adjust it for price differences – precisely using GNI. This is because the raw GDP per capita of a given country can be misleading.

Take India as an example. On paper, their GDP per capita looks very low compared to Western countries. But when you factor in PPP – that is, the fact that everything is much cheaper in India – the picture changes completely. It turns out that the average Indian family can buy much more for their money than raw exchange rates would suggest. That is why the International Monetary Fund and the World Bank use GDP adjusted for PPP – it provides a much clearer picture of the actual standard of living in individual countries.

Big Mac Index – the simplest way to understand PPP

To demonstrate how all this works in practice, it's best to use something that everyone knows. The weekly The Economist created the famous Big Mac Index. The idea is brilliantly simple: a Big Mac at McDonald's is almost identical everywhere, so comparing its price in different countries shows the actual purchasing power of individual currencies.

If a Big Mac costs 5 USD in the United States but only 3 USD in India, it clearly indicates how much weaker the Indian currency is compared to the dollar. Later, there appeared the iPad Index, the KFC Index – all based on the same principle: look at the products that people buy every day, and you will see the real value of money.

Purchasing Power Parity – where are the pitfalls?

Not everything is as simple as it seems. The main issue is differences in quality. A product may be more expensive because it is of better quality, even though it looks identical. Price comparisons can then be misleading.

The second challenge is non-tradable goods – things that are not exported. Apartments, hairdresser services, electricity, local taxes – the prices of these services are heavily dependent on local conditions and can vary dramatically even between nearby cities.

Add to this inflation. A comparison that makes sense today may be completely outdated in six months because prices have changed. PSN assumes relative price stability, but we all know how inflation can disrupt these predictions.

Currency Exchange Rate Predictions – Long-Term Play

Although exchange rates can fluctuate wildly due to political or speculative reasons, in the long run they tend to revert to values suggested by the PPP. Economists use this fact to create long-term forecasts regarding the behavior of currencies. If a currency is drastically undervalued or overvalued relative to PPP, there is a chance that it will equalize in the future.

PSN and the world of cryptocurrencies – why is it important?

Here the matter becomes particularly interesting for crypto investors. Bitcoin and other cryptocurrencies are global assets – they are not tied to any country or central bank. But how accessible they are to people depends on the purchasing power of their local currencies.

For people in countries with weaker currencies (according to PSN) purchasing cryptocurrencies is more expensive, but that is precisely why cryptocurrencies can be a lifeline for them against devaluation. In countries experiencing hyperinflation or high inflation, Bitcoin and other crypto assets are seen as ways to protect the value of savings.

Stablecoins play an even more important role here – cryptocurrencies pegged to the dollar or euro. In regions with weak currencies, stablecoins are a practical financial tool, allowing people to store value without exposing themselves to the risk of devaluation of the local currency. PSN helps assess whether converting from the local currency to a stablecoin makes sense – that is, whether the increase in value stability is worth the potential transaction costs.

Summary – PSN is more than an academic concept

Purchasing power parity is not just a topic for economists. For someone looking to invest, travel, or simply understand why prices are what they are – PPP is an invaluable tool. Whether you are comparing earnings between countries or wondering if switching to a stablecoin makes sense in your situation, the concept of PPP should be familiar to you.

By combining knowledge of the PSN with an understanding of GDP and changes in cryptocurrency markets, you can make better-informed financial decisions and better understand the dynamics of global markets.