Adjust for people and purchasing power before comparing average resources.
Different currencies, prices and population sizes make nominal totals misleading. A comparable PPP-adjusted per-person income or output measure improves a cross-country material comparison by accounting for purchasing power. It still needs distribution and non-material evidence. Identical CPI index values do not imply identical price levels: each index may simply use its own base year of 100.
- Currency and prices
- A market exchange rate tells you how much of one currency buys another. Converting both incomes to US dollars does not make local goods and services cost the same.
- Purchasing power parity
- Purchasing power parity (PPP) adjusts for price differences between economies. A comparable PPP-adjusted income per person helps show how much goods and services the average income can buy.
- Watch for this
- Separate CPI indices set to 100 do not establish equal living costs. Each 100 refers to that economy's own base period.
Worked example: Currency conversion is not enough
At market exchange rates, income per person is US$30,000 in A and US$20,000 in B. A comparable price basket costs US$15,000 in A and US$8,000 in B.
- The exchange-rate income figure is higher in A.
- For this basket, A's income buys 30,000 / 15,000 = 2 baskets. B's buys 20,000 / 8,000 = 2.5 baskets.
- Price differences can reverse the apparent purchasing-power ranking; a broad PPP comparison uses many goods and services.
Watch out for this
The country with the higher US-dollar income must have the higher material standard of living.
A common currency does not by itself give a common price level. Check a suitable purchasing-power measure and who receives the income.
Check your understanding
Both countries report CPI 100 in their own base year. What does that establish?
- Only that each index is normalised to its own base.
- Living costs are identical in the two countries.
- Their populations and incomes are equal.