Purchasing Power Parity - PPP
Developed in 1920 by Gustav Cassel, Purchasing Power Parity also referred to as Real GDP is based on the law of one price which says that in an efficient market, identical goods should have only identical price. The most used purchase power parity exchange rate is referred to as international dollar and is a hypothetical currency that has the same purchasing power as a US Dollar has in the United States of America.
PPP calculation is rife with controversy due to the inconsistency in finding baskets of goods that can compare the purchasing power across various countries. This arises out of the differing tastes and the difference in purchasing patterns seen in various countries.
One economist took a more entertaining approach of comparing the same by creating a Big Mac Index which is a way to compare the cost of a Big Mac sold by McDonalds across the world. This does not work in reality due to the input material and costs varying due to tastes of the local customers. Recently an australian firm also introduced the IPOD index as a entertaining way to measure PPP, but IPOD is considered a luxury item in many countries while the western economies consider it to be basic electronics.
Comments
The purchasing power parity (PPP) theory uses the long-term equilibrium exchange rate of two currencies to equalize their purchasing power. It was developed by Gustav Cassel in 1920, and is based on the law of one price. That is, in an ideally efficient market, identical goods should have only one price. For example, a purchasing power parity exchange rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods.
It is often used to compare the standards of living between countries, rather than a per-capita gross domestic product (GDP) comparison at market exchange rates. The best-known and most-used purchasing power parity exchange rate is the Geary-Khamis dollar (the "international dollar").