What Is Purchasing Power Parity (PPP)?

What is purchasing power parity (PPP)?
According to International Monetary Fund (IMF), PPP is defined as “The rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods and services in each country”

Gustav Cassel (1920) provided the modern definition of PPP. According to Gustav, when measured in the same unit, the monies from different countries should have the same purchasing power and buy the same basket of goods. Otherwise, price differences will create international arbitrage which will bring adjustments in prices, exchange rates, or both, this international arbitrage will ultimately restore parity. Another way to interpret the parity condition is that the exchange rate between two currencies should equal the ratio of the countries’ price levels.

How PPPs are calculated?
The process to calculate PPP is divided into the following three stages.

Product level: In this stage, for individual goods and services the price relatives are calculated first. In our example we can consider one litre Pepsi. If it costs 1 pound in the UK and 2.00$ in the US then the PPP for Pepsi between the US and the UK is 2/1, or 2. This means that for every

We get tradable PPP if aggregate price indices are made of tradable goods only. If aggregate price indices are made of non-tradable goods, we will get non-tradable PPP. Examples of non-tradable goods are haircut service, taxi rides, house rents, school fees, etc. Non-tradable goods are not traded and these are not affected by foreign prices. Haircut service is not tradable because it is very costly to get hairdressers from abroad, so people go to local shops. On the other hand, agricultural products are transportable but governments often do not allow free import, so they are artificially