Purchasing Power Parity:

Purchasing power is the ability of consumers to purchase goods and services with a specific amount of currency or
credit. The more goods and services that can be purchased with the same amount of money in any form, the higher
the purchasing power of the individual, business or other entity. Attempting to maximize thisbuying power is a
common goal for just about any entity, from individuals who are attempting to organize a household budget to best
effect to large multinationalcorporations that are seeking to maximize the returns on the proper use of their resources.

PPP is an economic technique used when attempting to determine the relative values of two currencies. It is useful
because often the amount of goods a currency can purchase within two nations varies drastically, based on
availability of goods, demand for the goods, and a number of other, difficult to determine factors. PPP solves this
problem by taking someinternational measure and determining the cost for that measure in each of the two
currencies, then comparing that amount. Or
Definition

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 contries 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).

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.

A simple example of a measure of absolute PPP is the Big Mac index popularised by The Economist, which looks at

the prices of a Big Mac burger in McDonald's restaurants in different countries. If a Big Mac costs USD$4 in the US

and GBP£3 in Britain, the PPPexchange rate would be £3 for $4. In the same way, if a Big Mac or any basket of

goods costs USD$4 in the US, the PPP exchange rateis always $4 for $4.
PPP equalization and the law of one price

The law of one price states that prices of traded goods will equalize in the absence of tariffs, other barriers to

trade and prohibitively highshipping rates. Free trade of goods should revert exchange rates to their PPP values; for a

discussion, see Discussion and clarification of PPP.

Application

A common measure of the standard of living is the per capita Gross Domestic Product, which is calculated by dividing

the GDP of a country by its population. In order to compare the standard of living in two nations, one first needs to

express these numbers in the same currency. Using actual exchange rates when making these comparisons can give

a very misleading picture of living standards. The PPP method is used to as an alternative.

For example, if the value of the Mexican peso falls by half compared to the US dollar, the Gross Domestic

Product measured in dollars will also halve. However, this exchange rate results from international trade and financial

markets. It does not 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 PPP exchange rates helps to avoid this problem.

PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments.

Countries with strong government control of the economy sometimes enforce official exchange rates that make their

own currency artificially strong. By contrast, the currency's black market exchange rate is artificially weak. In such

cases a PPP exchange rate is likely the most realistic basis for economic comparison.

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.

The balance of payments (BOP) is the method countries use to monitor all international monetary
transactions at a specific period of time. Usually, the BOP is calculated every quarter and every calendar year. All
trades conducted by both the private and public sectors are accounted for in the BOP in order to determine how
much money is going in and out of a country. If a country has received money, this is known as a credit, and, if a
country has paid or given money, the transaction is counted as a debit. Theoretically, the BOP should be zero,
meaning that assets (credits) and liabilities (debits) should balance. But in practice this is rarely the case and, thus,
the BOP can tell the observer if a country has a deficit or a surplus and from which part of the economy the
discrepancies are stemming.
The Balance of Payments Divided

The BOP is divided into three main categories: the current account, the capital account and the financial account.

Within these three categories are sub-divisions, each of which accounts for a different type of international

monetary transaction. 

The Current Account

The current account is used to mark the inflow and outflow of goods and services into a country. Earnings on

investments, both public and private, are also put into the current account. 

Within the current account are credits and debits on the trade of merchandise, which includes goods such as raw

materials and manufactured goods that are bought, sold or given away (possibly in the form of aid). Services

refer to receipts from tourism, transportation (like the levy that must be paid in Egypt when a ship passes through

the Suez Canal), engineering, business service fees (from lawyers or management consulting, for example), and

royalties from patents and copyrights. When combined, goods and services together make up a country's

balance of trade (BOT). The BOT is typically the biggest bulk of a country's balance of payments as it makes up

total imports and exports. If a country has a balance of trade deficit, it imports more than it exports, and if it has a

balance of trade surplus, it exports more than it imports. 

Receipts from income-generating assets such as stocks (in the form of dividends) are also recorded in the

current account. The last component of the current account is unilateral transfers. These are credits that are

mostly worker's remittances, which are salaries sent back into the home country of a national working abroad, as

well as foreign aid that is directly received. 

The Capital Account

The capital account is where all international capital transfers are recorded. This refers to the acquisition or

disposal of non-financial assets (for example, a physical asset such as land) and non-produced assets, which

are needed for production but have not been produced, like a mine used for the extraction of diamonds. 

The capital account is broken down into the monetary flows branching from debt forgiveness, the transfer of

goods, and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets

(assets such as equipment used in the production process to generate income), the transfer of funds received to

the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, and, finally, uninsured damage to

fixed assets.

The Financial Account

In the financial account, international monetary flows related to investment in business, real estate, bonds and
 stocks are documented. 

Also included are government-owned assets such as foreign reserves, gold, special drawing rights (SDRs) held

with the International Monetary Fund, private assets held abroad, and direct foreign investment. Assets owned

by foreigners, private and official, are also recorded in the financial account. 
The Balancing Act
The current account should be balanced against the combined-capital and financial accounts. However, as
mentioned above, this rarely happens. We should also note that, with fluctuating exchange rates, the change in the
value of money can add to BOP discrepancies. When there is a deficit in the current account, which is a balance of
trade deficit, the difference can be borrowed or funded by the capital account. If a country has a fixed assetabroad,
this borrowed amount is marked as a capital account outflow. However, the sale of that fixed asset would be
considered a current account inflow (earnings from investments). The current account deficit would thus be funded.

When a country has a current account deficit that is financed by the capital account, the country is actually foregoing
capital assets for more goods and services. If a country is borrowing money to fund its current account deficit, this
would appear as an inflow of foreign capital in the BOP.

What Does Balance Of Trade - BOT Mean?

The difference between a country's imports and its exports. Balance of trade is the largest component of a country's
balance of payments. Debit items include imports, foreign aid, domestic spending abroad and domestic investments
abroad. Credit items include exports, foreign spending in the domestic economy and foreign investments in the
domestic economy. A country has a trade deficit if it imports more than it exports; the opposite scenario is a trade
surplus.

Also referred to as "trade balance" or "international trade balance"

The balance of trade is one of the most misunderstood indicators of the U.S. economy. For example, many people
believe that a trade deficit is a bad thing. However, whether a trade deficit is bad thing is relative to the business cycle
and economy. In a recession, countries like to export more, creating jobs and demand. In a strong expansion,
countries like to import more, providing price competition, which limits inflation and, without increasing
prices, provides goods beyond the economy's ability to meet supply. Thus, a trade deficit is not a good thing during a
recession but may help during an expansion.

The balance of trade (or net exports, sometimes symbolized as NX) is the difference between the monetary value
of exports and imports of output in an economy over a certain period. It is the relationship between a nation's imports
and exports.[1] A positive or favorable balance of trade is known as a trade surplus if it consists of exporting more
than is imported; a negative or unfavorable balance is referred to as a trade deficitor, informally, a trade gap. The
balance of trade is sometimes divided into a goods and a services balance.