The Social Construct of Purchasing Power Parity

16560470-Abstract-word-cloud-for-Purchasing-power-parity-with-related-tags-and-terms-Stock-PhotoWhy are some countries rich while other countries are poor? And how is national income distributed? It really depends on how poverty and prices are measured and compared. One common construct used by the International Monetary Fund (IMF) is the idea of Purchasing Power Parity (PPP for short). In other words, if I make a Loonie in Canada, how much stuff can I buy in the U.S. with that Loonie? That really depends on what I want to buy in the U.S. PPP is only relative to how prices are socially constructed.

For example, if I want to buy a Big Mac in the U.S., it will cost me about 70% more in Loonies. If I want to buy a Big Mac in Canada with U.S. Dollars, it will cost me about 30% less. This is all based on actual exchange rates for the price of currencies. But the IMF has something different to say in using PPP. Under the PPP scheme, a Big Mac in the U.S. with Canadian Loonies will only cost me 16% more. Who is right? Obviously the cashier at McDonalds doesn’t care about PPP, he/she cares about the exchange rates that McDonalds is charged for the cost of converting currency; McDonalds will charge me the 30% difference.

What if I don’t want to buy Big Macs because I hate them? What if no one else wants to buy Big Macs? Then there’s no demand for Big Macs, and no matter what, the prices will drop regardless of the currency used. We see this a lot in cross-border shopping along border towns when certain goods and services are offered “at par” because they need to (A) get rid of stuff or (B) attract more customers. In this case, neither exchange rates nor PPP matter.

What about how poor are people who can’t afford a Big Mac in either country? Well, the IMF has a measure for that too, though more absolute than comparative. If a person makes less than $1.25 U.S. dollars in Purchasing Price Parity, then they are poor. If they make $1.26 for the same measure, then they are not poor; they are just “insecure.”

When looking at countries as a whole, many economists like to look at GDP per capita in PPP dollars. So if Americans make $45,000 (on average) then according to PPP it’s worth about 55,000 Loonies. If that were really the case, then Americans would be flocking to the Canadian bond market since Canada is offering higher interest than the U.S. with a surplus on exchange rates. But Americans aren’t lining up at the border to buy AAA rated Canadian bonds. Could it be because the PPP isn’t really there when other factors are present, such as regulations, fees, and the fact that Canada is largely a commodity exporter?

PPP is relative to a lot of things. PPP is relative to demand, exchange rates, the type and scope of a nation’s economy, the amount of skilled labor, and usually in comparison to the U.S. Dollar (which is problematic in its own rite). Since PPP is so relative, that means that it cannot really mathematically measure anything other than a social construct.

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This entry was posted in Labor, Macroeconomics, Markets, Poverty. Bookmark the permalink.

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