PPP and CPI

PPP and CPI

Purchasing Power Parity (PPP) and Consumer Price Index (CPI) are quite commonly used terms in macroeconomics. It is important to understand these terms in order to understand economic issues. In this blog I have tried to explain these terms in simple words.

Purchasing Power Parity (PPP)

PPP is measured by finding the values (in US Dollars) of a basket of consumer goods and services that are present in each country (such as rice, pulses, sugar, pencils, electricity cost, water cost, bus fare, etc.). Supposing that basket costs $25 in India and $ 100 in US, then the purchasing power parity exchange rate is 1:4.

GDP (PPP)

What sets GDP (PPP) apart from other economic indicators, such as GDP per capita or nominal GDP and real GDP is that GDP (PPP) takes the cost of living into account. This explains why GDP (PPP) is used to measure the quality of life in a country.

Utility of PPP

The concept of PPP is very useful for comparison. It gives an idea as to what living standard can be maintained in different countries by the citizens. From the above example it is clear that an Indian requires only 1/4th the amount to maintain the same living standard in India as he would have required in US.

PPP: Complexities

The concept is easy to understand but difficult to calculate because of complexities like:

  • What all should be included in the basket of goods and services to represent the population accurately?
  • Difficulties in comparing the consumption patterns of people of different countries or even within the same country.
  • Frequent changes in the prices of goods and services.

We should understand the concept and realize that it gives a fairly accurate, though approximate idea to compare countries.

Consumer Price Index (CPI)

CPI is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically. Sub-indices and sub-sub-indices are computed for different categories and sub-categories of goods and services, being combined to produce the overall index with weights reflecting their shares in the total of the consumer expenditure covered by the index. The index is usually computed monthly or quarterly in some countries, as a weighted average of sub-indices for different components of consumer expenditure. Such an index would show how consumer expenditure would have to move to compensate for price changes so as to allow consumers to maintain a constant standard of living.

Example: Calculation of CPI for One Item: Sugar
  • Base year 2004.
  • Current: Oct 2016.
  • Price of Sugar in Oct 2016 (Rs 40/kg)/ Price of Sugar in Oct 2004 ( Rs 25/kg) x 100 gives CPI in percent.
  • 40/25 x 100= 160%.

Example: Calculation of CPI for Multiple Items

Number of items are chosen and their weighted averages used.

  • Examples of items with assigned weightages: Food products (40%), medical care (4%), house rent (30%), clothing (5%), water& electricity (4%), transport (10%) and others (7%). The weightage is assigned to bring the value closest to represent the population being surveyed.
  • In the same way as the CPI for one item was calculated, CPI is calculated for multiple items. Example:
Item Weight Base Price Weighted Current Weighted
Base Value Price Current Value
Food Products 0.4 15000 6000 20000 8000
Medical Care 0.04 1000 40 1200 48
House rent 0.3 10000 3000 12000 3600
Clothing 0.05 2000 100 2500 125
Water & Electricity 0.04 3000 120 4000 160
Transport 0.1 800 80 1500 150
Others 0.07 4000 280 7000 490
Total 1 9620 12573
CPI= 12573/9620 x 100= 130.7

It shows that CPI in the example has risen by 30.7 %.

CPI: Utility

  • Annual percentage change in CPI is used as a measure of inflation.
  • CPI is used to adjust for the effect of inflation to calculate the real value of wages, salaries, pension, for regulating prices and for deflating monetary magnitudes to show changes in real values.
  • It is one of the most significant indices being watched to decide the interest rates in the country. If CPI is higher than a laid down figure then RBI will raise interest rates and lower them when it is below a certain value.

CPI: Complexity

  • There is no fixed or consensus method of selecting the items, measuring the prices of various goods and services and assigning weightages.
  • It is difficult to get a true representation in one figure of different consumers like:
    • Rich,
    • Middle class,
    • Lower middle class,
    • Urban population,
    • And rural population.

Thus understanding the idea of CPI is simple but calculating it is a difficult task and there is no absolutely accurate assessment possible. It remains an approximation.

Conclusion

I sincerely hope that I have succeeded in explaining the concepts of PPP and CPI. If you find it simple to understand then please share it with friends. In case the concepts are not understood then please send me your comments.
 

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