What Is Purchasing Power Parity? Why the Same Burger Costs Different Amounts

The market exchange rate is the price of one currency in terms of another, set minute by minute by traders. It tells you how many rupees you get for a dollar at the airport. It says nothing about what the rupees will buy once you have them, and in practice a dollar's worth of rupees buys far more in Delhi than a dollar buys in New York, because rents, wages, haircuts and restaurant meals are cheaper there.

Purchasing power parity asks a different question: what exchange rate would make a basket of goods and services cost the same in both countries? If a basket costs 100 dollars in America and 3,000 rupees in India, the PPP rate is 30 rupees to the dollar, whatever the market says. The rate is a measure of relative price levels, and the ratio between it and the market rate is a measure of how cheap or expensive a country is to live in.

In theory, if identical goods could be shipped freely, prices would equalise across borders and the market rate would equal the PPP rate; nobody would pay more for wheat in one country than in another for long. For goods that are traded, that is roughly true. The gap opens up with the things that cannot be shipped: a haircut in Mumbai cannot be exported to Manhattan, so its price is set by local wages, and local wages in a poorer country are lower.

The result is a systematic pattern first described by the economists Balassa and Samuelson. Poorer countries are cheaper, especially for services, so their currencies buy more at home than the market rate implies, and the poorer the country the larger the gap. Wealthy countries such as Switzerland and Norway are the mirror image: expensive at home, with market rates that make their citizens look richer abroad than they feel at the supermarket.

The Economist newspaper introduced the Big Mac index in 1986 as a light-hearted way to make the idea concrete, and it has outlived many serious measures. The burger is the basket: it is made to the same recipe almost everywhere, from local ingredients, labour and rent, so its price reflects a whole local cost structure. Divide the local price by the American price and you have a PPP rate for the burger; compare that with the market rate and you can say whether a currency looks undervalued or overvalued.

By that measure the Swiss franc is usually the most overvalued currency in the world and the currencies of South Asia and parts of Africa the most undervalued, which is roughly what the fuller measures say too. The index is crude, since a Big Mac in Delhi is not quite the same product in a market where beef is not sold and the burger is chicken, and since the burger's price reflects tax and competition as well as costs. But as a teaching device it has never been bettered.

The choice of rate changes the map. At market exchange rates the United States has the largest economy in the world and China second; at PPP rates China overtook the United States around 2014, and India rises from fifth to third. Neither ranking is wrong; they answer different questions. Market rates say how much a country's output is worth on world markets, which matters for trade, debt and buying imports. PPP rates say how much its people can consume at home, which matters for living standards and poverty. The rule of thumb:

• •Comparing living standards or poverty across countries: use PPP
• •Comparing the size of economies as they weigh on the world: either, with the difference stated
• •Working out what a salary is worth if you move: PPP, adjusted for the city
• •Trade, foreign debt, imports and travel money: market rates

The serious PPP figures come from the International Comparison Program, run by the World Bank, which every few years prices thousands of matched goods and services in nearly two hundred countries and builds the baskets from them. The work is difficult, since the same basket does not suit every country and quality is hard to match, and the results are revised in ways that can shift a country's apparent size by ten percent overnight. The Big Mac remains the one item priced everywhere on the same day, which is why economists who dismiss the index in public tend to check it in private.

Purchasing power parity is the exchange rate at which a basket of goods costs the same in two countries, and it differs from the market rate because services and rents cannot be traded and are cheaper where wages are lower. It is the right measure for comparing living standards, market rates are the right measure for trade and debt, and the Big Mac index is a serviceable shortcut to the whole idea.