Purchasing Power Parity (PPP) Theory Term Paper

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Basket of Goods the PPP exchange rate calculations are also controversial because of the difficulties involved in finding comparable 'baskets of goods' to compare purchasing power across countries. People in different countries typically consume different baskets of goods; assign varying priorities to different goods; and even the goods available for purchase may differ across countries. Moreover, what is considered a luxury in one culture could be considered a necessity in another. The PPP exchange rate would consequently vary greatly depending on the choice of goods used for the index and makes it vulnerable to errors due to a deliberate or accidental bias in calculations by the choice of a differing bundle.

Quality of Goods: While comparing the prices of goods in different countries for the purpose of calculating PPP, the quality of goods is not taken into account. For instance, a hat is considered to be just a hat although the value of a shoddily made hat would be considerably lower than that of a well made high quality hat.

Measuring Poverty with PPP International monetary agencies such as the World Bank and the IMF frequently use the purchasing power parity to measure global poverty.

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The approach has been severely criticized in a Columbia University Study in 2005 titled "How Not to Count the Poor." The study argues that employing "a concept of purchasing power 'equivalence' that is neither well defined nor appropriate for poverty assessment" has led the World Bank to "understate the extent of global income poverty and to infer without adequate justification that global income poverty has steeply declined in the recent period" (Reddy and Pogge, 2005)

Conclusion

The purchasing power parity (PPP) theory is a useful economic concept that helps economists to compare the 'real' purchasing power of people in different countries by equalizing their GDP on the basis of an adjusted PPP exchange rate rather than the market exchange rate. It can also sometimes help us to evaluate whether the currency of a particular is under or over valued. The theory should, however, be used with caution as it has its limitations mainly due to the fact that the conditions required for PPP such as the absence of trade barriers and transportation costs and tradability of all goods do not exist in the real world......

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