Purchasing Power Parity: How do we really interpret global prices?

Why is price comparison important in the international economy?

Imagine that a Hungarian worker and their Indian colleague earn the same amount on paper. Yet, the Indian colleague can buy much more with the same salary. The secret lies in the concept of purchasing power parity (PPP) – a tool that highlights how the actual value of money can vary radically from country to country.

Purchasing power parity means that the same products should be traded at different exchange rates in different countries, taking into account the local price levels. This is not only interesting for economists - it is essential for a real understanding of living standards and for global economic comparisons.

The Basics of the Theory: The Law of “One Price”

The basis of the PPP concept is the so-called “law of one price”. According to the theory – if there were no market barriers – identical products should cost the same worldwide. If a phone costs 500 dollars in the USA and 55,000 yen in Japan, then the correct exchange rate should be around 110 yen/dollar.

However, the analysis is not as simple as it sounds. Due to taxes, shipping costs, local demand, and other factors, prices vary. Therefore, economists examine a complete basket of goods – food, clothing, housing, energy – instead of a single product. The relative expensiveness or cheapness of this price collection shows the true strength of each currency.

Practical application: From Big Mac to iPad

One of the most famous PPP applications is the Big Mac Index, created by The Economist. Due to its simplicity, it is widely used: since McDonald's sandwiches are almost identical everywhere, they provide a quick insight into the purchasing power of a currency. If a Big Mac costs 5 dollars in America and 3 dollars in India, its price reflects the relative strength of the Indian rupee.

Similar comparisons have emerged using the iPad index or the KFC index. These tools make understanding PPP more accessible.

How does this shape the GDP calculations and the assessment of living standards?

We truly understand the significance of purchasing power parity when we compare the economic performance of countries. Per capita GDP can sometimes be misleading – India's GDP appears low compared to the USA when only exchange rates are used. However, when we use PPP-adjusted GDP, which takes into account the lower cost of living, the actual purchasing power of the Indian population becomes much more comparable.

The International Monetary Fund (IMF) and the World Bank use this method to draw a more accurate picture of global wealth and development. When comparing living standards, PPP allows us to understand that $50,000 may be sufficient to maintain a comfortable living in one place, while in another region it barely covers basic costs.

Currency Exchange Rates and Long-Term Forecasts

Although exchange rates may fluctuate for a short period due to political, market, or speculative factors, they generally converge to the levels indicated by PPP in the long run. Economists use this relationship to predict where the exchange rate may move over time. This is particularly useful for identifying governments that artificially maintain exchange rates.

Limitations and Challenges

We should not idealize the PPP. The product quality difference is one of the most important issues – a higher price for a product does not necessarily mean it is more expensive, but may indicate better quality. Prices for non-traded goods such as ( real estate and local services ) also vary, making them difficult to compare internationally.

Inflation can modify PPP-based calculations over time. A comparison that is valid today may become outdated in a few months if prices change significantly.

Cryptocurrencies and Purchasing Power: An Emerging Relationship

Although the cryptocurrency market and the traditional PPP concept are not directly related, interesting parallels can be observed. Bitcoin and other cryptocurrencies are global assets – not tied to any single nation. This means that in countries where the local currency is weaker, based on PPP, the purchasing power is lower, making crypto appear more expensive, but it offers a potential value retention opportunity.

This is particularly significant for countries transitioning through hyperinflation. Stablecoins provide a practical solution, as they allow people to hold a stable, dollar-pegged asset instead of their more limited local currency. In certain regions, this is already being used as a practical means of payment, although there are risks involved.

From the perspective of purchasing power parity, we can also examine whether it would be more beneficial for the residents of a country with a weak local currency to maintain stablecoin holdings for the stability of their securities.

Summary: Why is it important to us?

Purchasing power parity is important not just for a narrow circle of economists – it can be useful for all of us. Whether you are planning pricing strategies at the corporate level or simply traveling and wondering why everything is more expensive or cheaper, PPP helps to interpret global prices in real terms.

The logic behind the law of one price is simple: the real value of a currency is what you can actually buy with it, not the number of the exchange rate. Keeping this in mind, the economic differences between countries become much clearer, and the question of why the same standard of living can come from seemingly different salaries.

Disclaimer: This content is for general informational purposes only. It does not constitute financial, legal, or other professional advice. The price changes of digital assets can be interesting or may lose their value. Make your investment decisions based on your own judgment.