Much economic analysis concentrates on what is happening within an individual country and, because economic statistics produced by the national statistical agency are expressed in the domestic currency, comparisons can be made easily between different sets of domestic data. However, from time to time, economists are interested in comparing economic data from different countries. In some cases, (e.g. such as comparing the recent growth rate of Gross Domestic Product (GDP) in Australia with that in the United States of America (USA)) it is fairly easy to do so. In this case, the monetary units in which the underlying data are expressed are not important because it is the rate of growth rather than the level of activity that is being compared. Other types of comparisons are less straightforward. For example, there is often interest in the relative levels of activity between countries or in obtaining an overall total measure of activity for a group of countries such as those in the Organisation for Economic Cooperation and Development (OECD). It is common to see figures quoted for the level of GDP per capita in countries, as a rough measure of relative economic wellbeing, or an overall growth rate for, say, the whole of the 30 OECD countries. In the former case, the main problem in making the comparison is in adjusting the data expressed in national currency units to a common currency such as the $US. In the latter case, it is necessary to aggregate across different currencies ($A, euro, British pound etc.).
One method of converting economic data from a national currency to a common currency such as the $US is to simply use exchange rates. An exchange rate represents the ‘price’ of a foreign currency (i.e. the number of units of the domestic currency required to purchase one unit of a foreign currency). As such, it is clear it is appropriate to use exchange rates for applications such as calculating the amount of goods and services that could be imported with the proceeds of a particular level of exports or calculating the domestic currency costs of purchasing foreign goods and services abroad. However, in assessing relative standards of living, what is required is a means of comparing the volumes of goods and services actually available to residents of different countries in their own countries. Using exchange rates to convert the national currency values can be misleading because exchange rates are influenced by factors other than relative domestic price levels (e.g. financial flows and interest rate differentials can have a significant effect on exchange rates). In practice, exchange rate based comparisons of poor countries with economically developed countries are systematically biased downwards which has the effect of exaggerating their apparent differences in income. PPPs are specifically designed to provide rates of currency conversion that equalise the internal purchasing power of different currencies. Converting national currencies using PPPs eliminates the effects of different price levels between countries.
The simplest example of a PPP is regularly presented by The Economist magazine, which shows the relative levels of the prices of Big Mac hamburgers between various countries. This form of presentation provides an indication of which countries are ‘expensive’ (i.e. those whose PPP for a Big Mac is higher than the equivalent price based on exchange rates) and those that are ‘cheap’. More sophisticated PPPs are constructed by reference to the relative prices of a much broader range of goods and services.
To calculate PPPs, it is necessary to identify identical goods and services in the countries involved in the comparison and for which prices can be collected. The goods and services concerned need to be representative of the expenditures in each country as well as being comparable between the countries. Tensions arise in identifying products that meet these two criteria, so compromises have to be made in the process.
However, if the quality of a country’s national accounts and/or prices information is poor, then the quality of the PPP statistics for that country will also be poor. It should be noted that poor quality national accounts data will also adversely impact on the quality of exchange rate based comparisons, in addition to the other concerns with this method of comparison that are set out below.
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