The theory of Purchasing power parity (PPP) asserts that in equilibrium the exchange rate that will prevail between two countries will be that which equalizes the prices of traded goods in each country. Typically, the prices of many goods would be looked at, weighted according to their importance in the economy.
Purchasing power parity exchange rates are useful for comparing living standards between countries. Actual exchange rates can give a very misleading picture of living standards. For example, if the value of the Mexican Peso falls by half compared to the dollar, the Gross Domestic Product measured in dollars will also halve. However, this doesn't necessarily mean that Mexicans are any poorer - if incomes and prices measured in pesos stay the same, they will be no worse off assuming that imported goods are not essential to the quality of life of individuals. Measuring income in different countries using purchasing power parity exchange rates helps to avoid this problem.
One issue with PPP is, however, that most sources do not state the actual content of the PPP, which is statistically deceiving e.g. Countries at Economist.
A simple and humorous example of a measure purchasing power parity is the "Big Mac index" popularised by The Economist magazine, which looks at the prices of burgers in McDonald's restaurants in different countries. If for example a Big Mac cost 4 US dollars in the US and 3 pounds in Britain, the purchasing power parity exchange rate would be 3 pounds for 4 dollars. However, if in the scenario 1 dollar could be traded for 1 pound, then the theory of PPP sudgests that over time the real exchange rate will change to match the PPP exchange rate.
The exchange rate says how much you can buy in another country with one unit of your own currency. But purchasing power parity exchange rates has nothing to do with how much you can buy.
Some critics claim that the CIA Factbook is using the PPP to sex up the U.S. statistics, because pure numbers the US has a slighly lower GDP per capita than Germany and a much lower GDP per capita than Japan.
Even if a correct PPP is used, GDP per capita is still a measure of the economic output of the whole economy, not a direct measure of the mean or median person's quality of life. Other factors such as the quality of homes and schools, access to public services, the extent of pollution, and strength of consumer protection laws are hard to quantify and generally not fully reflected in the GDP. Thus, even a PPP-adjusted measure of GDP per capita must be used with caution, as it is only one component of quality of life.
For example, in 2002, the GDP per capita for Japan is about $40,000, while the PPP is estimated as $27,000, while in the US, GDP per capita is about $27,500 and the PPP is $36,000. The U.S. has poverty, high crime rates and slums to a greater extent than Japan, while Japan has much less physical space per person and arguably less individual freedom. Ultimately, the quality of life may depend on subjective judgement and individual preferences.
Per capita income also does not take into account inequalities in wealth distribution.
See also: Measures of national incomeCriticism of PPP
It is wrong to assume that the prices of goods should be equal in all countries. People in different countries usually put different values on the same goods. What is a luxury goods in one country can be an ordinary daily goods in another country. PPP disregards this. Quality of Life and PPP
