Whilst the most exchange rates, in and of themselves, make certain kinds of cross national comparison, they are obviously limited in scope. Nonetheless if any monetary values are to be used in making cross national comparisons, different local currency units need to be converted to a common monetary base. Purchasing power parity (PPP) exchange rates are published to do this. Conceptually such a rate is a combination of price index and exchange rate. The OECD provides a good PPP explanation.

Internationally traded and non traded goods

It is frequently observed that, from the viewpoint of a foreigner, goods in a country visited are either much more expensive or much cheaper than at home, measured in terms of their own currency converted to the foreign currency at market exchange rates. This is because foreign currency is basically required to trade goods and services (consumption or investment goods) or to participate in financial dealings in another country. However these transactions represent only a part of those undertaken in the foreign country. Many goods and services are not traded cross nationally. A common example of such a service is a haircut. Prices and conditions of these non-internationally-traded goods therefore do not influence foreign exchange markets. Yet for the inhabitants and visitors to a country they can be a very important part of their expenditure. The cost of buying goods in a country with comparatively cheap non-internationally-traded goods will be less than buying similar goods where they are high priced.

Purchasing Power Parity exchange rates

In other words a fixed amount of home currency will buy different quantities of similar goods in other countries if non-internationally tradables have different prices. Purchasing Power Parity exchange rates allow for this difference. Conceptually they are calculated as the ratio of the cost of buying a standard, or highly comparable, bundle of goods in different countries using the indigenous currency in each. A purchasing power parity exchange rate between two countries would mean that the standard bundle of goods would cost the same in each of the two countries. A euro would buy the same number and quantity of haircuts, meals, video games etc. in Europe as it would if exchanged for rupees and used to buy those goods in India.

Purchasing Power Parity exchange rates are not prices that emerge from markets. They are international price indexes calculated by national income statisticians.

PPP exchange rates can be found in the OECD databanks for OECD countries and World Bank databanks for other countries.

Who is responsible for PPP exchange rates?

In OECD and EC countries PPP rates are the responsibility of the Joint OECD-Eurostat PPP Programme. The International Comparison Programme managed by the World Bank is responsible for PPP rates in countries not covered by the OECD-Eurostat programme.

How PPP rates are calculated

A mixture of goods and services (within 'headings'), both internationally traded and non-traded is determined. It must contain goods comparable between all countries to be covered by the PPP rate.

National statisticians calculate the prices of each good or service in local currency units and in an international base currency (denominated as US dollars). For each good, their ratio gives an exchange rate between the local currency and the international base currency that would equalise the price of that good whether denominated in the local or base currency.

These disaggregated exchange rates are then combined with sets of weights to give rates applicable to more general headings and the economy as a whole, i.e. up to the highest level statistics such GDP and GNI (see later sections). The rates at this level are the PPP exchange rates for that economy. The World Bank publishes a good summary of how PPP rates are calculated.

The main method used to compute PPP exchange rates is a version of the 'EKS' system. See the UN Handbook of the International Comparison Programme for more detail. This enables PPP exchange rates to be transitive; all binary rates (rates between any two countries) are consistent with each other.

The use of PPP rates

PPP exchange rates can be thought of as 'spatial' price indexes. They are crucial in making cross -national comparisons of 'real' levels of economic and related activity. Many series are deflated by a PPP exchange rate to show the 'volume' measure; actual production or consumption etc. allowing for the fact that different economies have different price levels.

Base years and updating

PPP rates can be 'current' or 'constant'.

PPP rates are 'benchmarked' (i.e. based on a new survey of prices) every year in European OECD countries, every 3 years for non-European OECD countries and every 5 years for ICP countries.

Current PPP rates are those that use the latest benchmark information.

Constant PPP rates are based on PPP rates in a specified year, updated by a consumer price index.

For further discussion see later sections