Archive:Purchasing power parities (PPPs) - calculation and uses

Purchasing power parities (PPPs) are indicators of price level differences across countries. PPPs tell us how many currency units a given quantity of goods and services costs in different countries. PPPs can thus be used as currency conversion rates to convert expenditures expressed in national currencies into an artificial common currency (the purchasing power standard (PPS), eliminating the effect of price level differences across countries.

For many years, Eurostat, together with the OECD, has run the European comparison programme. The aim is to compile purchasing power parities, which are a kind of alternative exchange rates that allow a comparison of, for example, gross domestic product (GDP) across countries, that is unaffected by differences in price levels between the countries.

Introduction

To compile purchasing power parities (PPPs), prices of a basket of comparable and representative goods and services are collected in all participating countries. For consumer products, in total about 3 000 products are priced. In addition, information is gathered about prices for housing, investment goods (including construction services) and government services.

Currently, 46 countries participate in the European comparison programme, of which 37 are European countries, whose survey work is coordinated by Eurostat, while the other nine countries are non-European OECD countries. The 37 countries in the Eurostat part of the exercise comprise all 27 Member States, three EFTA countries, three candidate countries and four western Balkan countries, although the latter are not yet fully integrated.

Data collection on consumer goods and services are carried out in continuous cycles. Each cycle takes three years and comprises six surveys, two each year. This means that each product is priced once every three years. For the intervening years, the prices are extrapolated with suitable consumer price indices. The advantages of this approach are that it reduces the response burden on participating countries, it enables them to include the price surveys in their regular programme of data collection and it fosters continuity of expertise in the NSIs.

The PPPs calculated by Eurostat and the OECD are also used in the international comparison programme (ICP) run by the World Bank. This programme comprises currently around 150 countries around the world. The ICP published PPPs for the year 2005 in the second half of 2007.

Calculating PPPs

The production of PPPs is a multilateral exercise involving the national statistical institutes of the participating countries, Eurostat and the OECD.

PPPs make it possible to produce meaningful volume or price level indicators required for cross-country comparisons, truly reflecting the differences in the purchasing power, for example, of households. Monetary exchange rates cannot be used to compare the volumes of income or expenditure because they usually reflect more elements than just price differences (e.g. volumes of financial transactions between currencies, expectations in the foreign exchange markets).

Purchasing power parities are obtained by comparing price levels for a basket of comparable goods and services that are selected to be representative of consumption patterns in the various countries.

PPPs are, at the lowest level, bilateral price relatives between tightly defined individual items (e.g. one loaf of bread in the United Kingdom, GBP 1.50, to EUR 2.00 in Germany). Subsequently, these relatives are turned into multilateral relatives and scaled to the European Union (EU) average and aggregated to more and more complex aggregates (e.g. food) and finally to the whole gross domestic product (GDP). PPPs are aggregated price ratios calculated from price comparisons over a large number of goods and services.

Use of PPPs

PPPs are employed as either:

currency converters to generate volume measures with which to compare levels of economic performance, total consumption, investment, overall productivity and selected private household expenditures;
price measures with which to compare relative price levels, price convergence and competitiveness.

Eurostat produces three sets of data using PPPs:

levels and indices of real final expenditure – these are measures of volume; they indicate the relative magnitudes of the product groups or aggregates being compared; at the level of GDP, they are used to compare the economic size of countries;
levels and indices of real final expenditure per head – these are standardised measures of volume; they indicate the relative levels of the product groups or aggregates being compared after adjusting for differences in the size of populations between countries; at the level of GDP, they are often used to compare the economic well-being of populations;
comparative price levels – these are the ratios of PPPs to exchange rates; these indices provide a comparison of the countries’ price levels with respect to the EU average – if the price level index is higher than 100, the country concerned is relatively expensive compared with the EU average and vice versa; at the level of GDP, they provide a measure of the differences in the general price levels of countries.

Key for allocation of EU Structural funds

The PPPs are compiled on an annual basis. Twice a year, in June and December, the latest price survey results are incorporated to calculate the freshest PPPs. The main derived indicator is real GDP per inhabitant, which is the GDP per head of the population divided by the PPPs. An important use of this indicator is for the allocation of the Structural funds within the EU. Regions where real GDP per capita is less than 75 % of the EU average (taken over a period of three years) are eligible for Structural funds.

Comparing price levels of products

Another output of considerable interest to users is the resulting price level indices. For any category of products, these are calculated by dividing the PPPs by the exchange rates. If the result is higher than 1, the price level for this product in this country is higher than the EU average. If the result is lower than 1, the price level is lower than the average. Eurostat publishes the results of the price surveys at regular intervals.

Why PPPs and not exchange rates?

Why would one use PPPs instead of exchange rates when converting economic indicators into a common currency? Consider the graph below comparing GDP per inhabitant of the EU-27 and the United States.

The green line shows the ratio of GDP per inhabitant between the US and the EU-27 if the US GDP was converted into euros using the exchange rate. As the development of the exchange rate between the euro and the US dollar was rather volatile in this period, it appears as if US citizens have had a turbulent time, especially in 2002 and 2003. However, that would of course not reflect their actual situation in those years. If we would divide the US GDP by the PPP between the EU-27 and the US the trend would be as depicted by the pink line, i.e. an almost stable pattern. “PPS” stands for “Purchasing power standard” which is an artificial currency unit defined so that GDP per inhabitant in the EU-27 in euros equals that in PPS.