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Comparing currencies, realistically!

By HARSH AGARWAL

30th Aug 2022

3 mins read

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An average American family with an annual income of $100k will live a pretty ordinary life. But, if you convert those $100k into INR, it becomes Rs 79,87,220. With this amount, a family can afford the best education for their children, yearly trips, a couple of cars, etc.

This stark contrast testifies to the factors that determine a currency's power. Therefore, let us understand the elements in a detailed manner.

What is PPP?

Purchasing Power Parity (PPP) compares the purchasing power of different countries using the basket of goods approach.

What is a basket of goods?

A basket of goods is a constant collection of various goods and services that an average citizen uses in a country. It depicts the change in the cost of consumer goods and services over time.

It means that the conversion factor is deleted from the picture. Instead, it focuses on more critical markers like the cost of living, the cost of various inputs to a business and the market in general.

Multiple categories of consumer goods are then assigned weights. This process, however, involves the collection of vast amounts of data. National Statistics Organisation (NSO) has undertaken this task in India. The change in the price of this basket helps one track metrics like Consumer Price Index (CPI) and Purchasing Power Parity (PPP).

Why is PPP important?

As with stocks and equities, being linked to the open market, the conversion cost can be highly volatile, thanks to market sentiments, short-term economic policies, and market manipulation(in some cases).

However, the change in PPP results from long-term economic and political policies that affect the living conditions of an entire population. This helps international organizations like World Bank and the International Monetary fund, among others, to make predictions and recommendations to the countries.

How has the rupee fared in comparison to the dollar?

Let us look at a comparative analysis between the conversion rates and purchasing power parity of the Indian Rupee.

Image Source - www.ceicdata.com
Image Source - www.walletinvestor.com

The chart shows that the conversion between the pairs has been way more volatile than the "real" value of INR against USD.

What are the drawbacks of this method?

As practical as this economical method may seem, it has certain flaws. One must consider these before blindly trusting the metric!

  • Imported goods and services

While the cost of production of a good or delivering a service in a country may be substantially lower than in others, it must be noted that it might not always be possible or feasible to obtain a good or service from within a country and must be imported from overseas. These would attract standard prices prevalent in the land of origin and various duties associated with importing the commodity.

  • Taxation

Working individuals often prefer a country with a higher cost of living if the government offers a lucrative tax policy on income and goods.

Conclusion

Despite various flaws, PPP is a standard method for comparing living standards of multiple countries and is a less prone metric to market manipulations than conversion rates that are often subject to money markets.

This also makes us wonder, what would various Forbe's lists look like if they were based on PPP rather than conversion rates? Ponder this question, and let us know your thoughts in the comments.

Till then, Stay Safe! Invest Safer!!

FAQs

Q. What is Consumer Price Index (CPI)?

Ans.  A consumer price index (CPI) is a price index that measures the cost of a weighted average market basket of consumer goods and services bought by households.

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