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In economics, purchasing power parity (PPP) is a method used to calculate an alternative exchange rate between the currencies of two countries. The PPP measures how much a currency can buy in terms of an international measure (usually dollars), since goods and services have different prices in some countries than in others.

PPP exchange rates are used in international comparisons of standard of living. A country's GDP is originally tallied in its local currency, so any comparison between two countries requires converting currency. Comparisons using real exchange rates are considered unrealistic, since they do not reflect price differences between the countries. The differences between PPP and real exchange rates can be significant. For example, GDP per capita in Mexico is ca. 6,100 U.S. Dollars, while on a PPP basis, it is 9,000$(U.S. GDP/capita is 37,388$, as of 2004).

 Contents

## Definition

PPP is a theoretical exchange rate derived from the perceived parity of purchasing power of a currency in relation to another currency. It takes into account that some goods like real estate, services (e.g. medical services) and heavy items are non-traded , and thus not reflected in the exchange rate. In contrast to the "real" exchange rate that the currencies are traded for in the official market (as opposed to the black market), the PPP exchange rate is calculated from the relative value of a currency based on the amount of a "basket" of goods the currency will buy in its nation of usage. Typically, the prices of many goods will be considered, and weighted according to their importance in the economy. The most common PPP exchange rate comes from comparing goods in a GDP reporting area with equivalent goods in the United States and through that come up with a PPP US dollar exchange rate. When GDP numbers from reporting regions are converted through this PPP exchange rate it's considered to be a better comparison of standard of living.

## Method

The PPP method considers a bundle of goods, then calculates the price of this bundle in each country (using the country's local currency.) To calculate the exchange rate between two currencies, one takes the ratio of the prices.

## PPP: clarification and discussion

Main article: Discussion and clarification of PPP

The main reasons why PPP does not perfectly reflect standards of living are

• PPP numbers can vary with the specific basket of goods used, making it a rough estimate
• Preferences and choices can vary from country to country. Goods then differ in their contribution to welfare.
• International competitiveness is mainly affected by the exchange rate, not PPP
• Differences in quality of goods are not sufficiently reflected in PPP.