What is purchasing power parity?

Market exchange rate or the exchange rate we often use fails to express the real purchasing power of Rupee in India while expressing India’s GDP, Per Capita Income etc., in Dollar terms. Most international comparisons on economic indicators are expressed in terms of official exchange rate. But we all know that on Dollar will purchase less commodities in the US compared to what Rs 60 can purchase in India (we assume that 1$ =Rs 60).

Hence, an alternate technique is needed to express India’s economic fundamentals while expressing them in terms of US Dollar. An important and popular technique is the Purchasing Power Parity (PPP) method. Under PPP, we use the purchasing power of currencies in respective countries to accurately measure different economic indicators like GDP, GDP Per capita income etc.

What is Purchasing Power Parity?

Purchasing power parity is defined as the number of units of a country’s currency required to buy the same amount of goods and services in the domestic market as one dollar would buy in the US.

The technique of purchasing power parity allows us to estimate what exchange between two currencies is needed to express the accurate purchasing power of the tow currencies in the respective countries.

Why we are using PPP?

We have observed that the market exchange rate doesn’t reflect the purchasing power of a currency.

Example

Imagine that the market exchange rate between Dollar and Rupee is 60. One Dollar in the US will buy one liter of milk there. Corresponding money in terms of Rupee i.e., Rs 60 can buy three liters of milk in India.

Suppose that India’s GDP is Rs 600. This will become $10 in market exchange rate terms. If milk is the only commodity produced in the world (you imagine it for simplicity sake), one will think that India is producing 10 liters of milk, if we use the market exchange rate.

Actually, India produces 30 liters of milk. This higher volume of production in India is not expressed if we use the market exchange rate to measure GDP.

To overcome this defect and to accurately measure the GDP, we can use the Purchasing Power Parity exchange rate.

Under PPP, we measure the GDP of India by measuring how much milk that Rupees 60 can purchase in India and One Dollar can purchase in the US.

Here, one dollar in the US can purchase one liter of milk whereas Rs 20 can purchase one liter of milk in India.

$ 1 = Rs 20

This is the purchasing power parity exchange rate we obtained. Using this exchange rate we can calculate that India’s GDP of Rs 600 will become $30.

Thus, in terms of PPP, India’s GDP is $30 in contrast to the $10 we estimated by using market exchange rate.

The PPP exchange rates help to minimize misleading international comparisons that can arise with the use of market exchange rates.

If you ask how much units of Indian currency is equivalent to one US Dollar in terms of PPP, the World Bank has estimated it scientifically.

The World Bank is using purchasing power parity conversion factor to correctly represent the PPP exchange rate. As per the WB estimate, 17.12 Indian Rupee is equal to one US Dollar in terms of purchasing power in 2014 (Source: ).

Estimation of 17.12 requires lot of calculation after assessing the prices of many goods and services in the US and India.

Comparing India’s GDP and GNI Per capita in terms of official exchange rate and PPP method

World Bank estimates GDP, GNI per capita income etc in both current US Dollar terms (market exchange rate) and PPP terms.

The trend is that India’s GDP in terms of PPP is much larger than the GDP we obtain by measuring it with official exchange rate. Same is true for per capita income as well.

Following part gives the WB estimate of GNI per capita income of India for 2014.

  • GNI Per capita Income for India (market exchange rate) - $ 1610
  • GNI Per capita Income for India (PPP terms) - $ 5760

(Math for you: = 17.12 x (5760/1610) = 61)

This means that the official exchange rate was $1 = Rs 61 in 2014.

India becomes the third largest economy (PPP terms)

Recently, India became the third largest economy in terms of PPP. China became the largest defeating the US to the second position. But India is at the ninth position in terms of Current Dollar terms.

India’s GDP in terms of Current US Dollar – $ 2.066 trillion

Here, India is the ninth largest economy in the world. US and China are the first and second. But in terms of PPP, India’s GDP is $ 7.4 trillion.

Here, India is the third largest economy. China is the largest economy, piping the US to the second position.

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