Purchasing Power Parity in Finance

We all know, when the prices of goods increase in inflation, purchasing price of currency will decrease. If prices of goods decrease, purchasing power of currency will increase. If we measure the exchange rate of different currencies on the basis of purchasing power, it is called purchasing power parity.

In other words, purchasing power parity adjusts the current currency's exchange rate on the basis of buying cost of products. For example, we eat 12  banana in India by paying Rs. 50. But in USA, there is $ 12 for 12 banana. This difference is surely due to exchange rate. If market exchange will change, prices will change. But market exchange rate is not changed scientifically. If there is political and economical unstability in any country, GDP will go down in any year, market exchange rate will change fastly. So, true exchange rate is calculated on the purchasing power of goods in different countries.

If Banana in India is  Rs. 50 for 12 buying, it should be $ 0.85 in USA because today exchange rate is one usa dollar to Rs.  58.91.

As per purchasing power parity, we calculate exchange rate on following formula


There are lots of uses of measuring exchange rate on the basis of theory of purchasing power parity which we can explain on the basis of following points.

1. To compare standard of living of Different Countries

If today is the rate of currency $ 1 to Rs. 58.90, then banana rate should be $ 0.85 but banana rate in USA is $ 12 for buying 12 banana. It means, cost of standard of living in USA is more than in India. Even at current exchange rate, it is not easy to live in USA. So, all those who go to other country should calculate ppp rate also.

2. Comparison of Economic Growth

Theory of PPP is also helpful to comare the economic growth of any country. You will see that rate of banana of every day will be different in India and in USA and on this basis, PPP rate will be different. By study current market exchange rate, PPP rate, we can compare the growth trend of two countries economy.


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