Decoding PPP

Our first video spoke about the contrasting growth experiences of South Korea and India over time, and wondered why the experiences were so different.

We haven’t answered that question yet, although we shall begin to, in just a little while. But in order to understand the question itself better, we’ve put together a series of articles. The horizontal axis on the wealth and health chart compares GDP per capita, adjusted for inflation and adjusted for PPP. And compares this metric for many countries over 200 years.

What’s GDP, what’s inflation and what’s PPP? Three questions, requiring three separate blog posts. There’s one on understanding what GDP is all about, one on making sense of inflation, and now this one, on PPP.

PPP stands for Purchasing Power Parity. If inflation adjustment allows you to compare data across time, then PPP adjustment allows you to compare data across space. What exactly does this mean, and why is it necessary?

How many rupees will one dollar get you today? Or, to speak in the language of financial markets, what is the rupee-dollar exchange rate? Well, rounding off for convenience, it is about 65 rupees per dollar. Give me one dollar, and I’ll happily trade you around 65 rupees for it.

But, and here’s the important question, will one dollar in America buy me the same things that 65 rupees does in India? I can walk into a roadside barber shop in India and get a shave for roughly that amount. But a shave from a barber in America will quite easily cost ten times as much, maybe more – I’m informed that it is around ten dollars for a shave in America, excluding tips.

So yes, one dollar may trade for sixty five rupees, but these two amounts don’t purchase the same things in both countries. There isn’t, in other words, parity (sameness) in the purchasing power of sixty five rupees in India and one dollar in America.

And that’s a problem, right? Because if sixty five rupees buys for you rather more than does one dollar, then that exchange rate is slightly misleading. So what is to be done?

What economists do is the following: they come up with a basket of goodsFOOTNOTE: Footnote that is more or less the same across countries, and ask: how many units of local currency will be required to buy this basket? Let’s say it is x rupees to buy this basket of goods in India, and y dollars to buy it in America.

x/y then becomes the PPP adjusted exchange rate.

That’s the simple version, and the real story is rather more complicated, but this is what PPP is – ignore the exchange rate, and adjust for the purchasing power of the two currencies. What this allows you to do is compare GDP per capita numbers across countries – which is what Gapminder is showing us in that first video.