purchasing power parity (1920) , or PPP for short, is a way to compare the value of money from country to country and from year to year. It compares money against the price of a fixed basket of goods: a set of goods, like food and housing, that gives you an idea how much the cost of living is.
A simple example is The Economist’s Big Mac Index. The Big Mac, which makes for a good meal in the middle of the day, is sold in 120 countries by McDonald’s. It is the same everywhere.
Being the same everywhere, the Big Mac must have the same value everywhere. This gives us a quick way to compare the value of money between countries and between years.
For example, a Big Mac in 2007 costs $3.22 in America and 280 yens in Japan. That means that 87 yens equals one dollar. This is called the real exchange rate.
But no one uses the real exchange rate in real life. It is just a theory. An American who went to Japan to get a Big Mac would have changed his dollars to yens at the nominal exchange rate that banks use, which is currently 121 yens to the dollar, not 87.
But this nominal exchange rate is only affected by things that can trade worldwide, like cars and gold and oil. It is not affected by the price of food, housing, transport or maid service – things close to home.
Some say that the two rates over time come into a rough balance. In fact, The Economist applies this idea to the Big Mac Index to find out whether the dollar will rise or fall against the yen.
But there is more: the Penn effect. This says that things are more expensive in rich countries than in poor ones. With the growth of industry, workers can produce more so they get paid more. But that raises the price of everything else. Including a meal at McDonald’s.
This is different than inflation. Inflation is when prices go up because the government prints too much money. In the 1900s both the dollar and the pound lost most of their value because of this.
Inflation has nothing to do with the Penn effect. Even measured in silver or gold, prices are still higher in rich countries and go up as a country becomes richer.
In Shakespeare’s time a kilo of bread cost 1.3 pennies or 0.66 grams of silver ($0.29). It now costs 5.4 grams or eight times as much. It is not because the bread is eight times better or eight times scarcer. Hardly. It is because people in England now make 100 times more.
But because of the Penn effect, the people in England are not 100 times better off, but only 12 times. A sign of this is that England can support ten times more people now then it could in Shakespeare’s time.
– Abagond, 2007.