On the other hand, a US Dollar has more purchasing power than a Pakistani or Indian Rupee. These differences are usually because of availability and demand for the goods amongst other factors. By taking an international measure and determining the cost for that measure in each of the two currencies and comparing them we can solve this problem. (McGuigan, 2008)
This formula represents the exchange rate of one currency in relative terms to another currency. P1 is the price of an item in one currency while P2 is the price of the same item in another currency (Investopedia, 2008).
Although according to this theory, the relative prices for a same product should be equal in two different locations. However we rarely see this happen. This theory doesn't even hold true in areas inside a city. For example in a high end posh area of a city might sell the same product at a much higher rate than the shop set up in a low end area.
This brings us to the most popular example of purchasing power parity, the Big Max Index. Calculated by the Economist Magazine, the Big Mac index is used to find the exchange rate to determine the value of other items. Since McDonalds is virtually in every country, this index is readily applicable. All we need is the price of Big Mac in the two countries we need to find the exchange rate of. For example a Big Mac in US costs around $4 while a Big Mac in India costs Rupees 200 thus the index will be $1 equivalent to Rs. 50. This index is used further to get an idea of the actual exchange rate in the market and to determine the relative value of other items. (McGuigan, 2008)
The main use of the index is to find the GDP and hence the standard of living of the people in a certain location. When we are determining the Gross Domestic Product of a country, a fall in the value of the currency relative to another base currency, will make the GDP fall by the same value. Taking the same example of the Indian Rupee and the US Dollar, a fall in the Rupee by 50%, will force the GDP expressed in US dollars to drop to 50%. This piece of information does not reflect true picture of the situation since the devaluation of the Indian currency maybe due to the international trade issues. However when we look at each day's exchange rates of the Dollar to the Rupee, we see fluctuations coming each day. But when we use the Big Mac index, these fluctuations are not reflected into the price of Big Mac each day. The price of the Big Mac remains to be Rs. 200 for quite a while even though the value of Dollar is increasing.
Purchasing Power Parity - Analysis
When we talk about the long-run, the purchasing power parity theory tells us that differences in the prices of the items in different countries are not sustainable as forces acting in the market place will equalize prices between countries and change exchange rates in doing so. Consider an example of a person who finds that the price of tomatoes is $5 lesser in another state. Traveling to the other state will cost the person $50 in fuel, thus just to save $5, this trip will incur a loss to the person. But when you consider bulk purchase this scenario comes out to be completely