Purchasing power parity is both a theory about exchange rate determination and a tool to make more accurate comparisons of data between countries. It is probably more important in its latter role since as a theory it performs pretty poorly. Its poor performance arises largely because its simple form depends on several assumptions that are not likely to hold in the real world and because the amount of foreign exchange activity due to importer and exporter demands is much less than the amount of activity due to investor demands. Nonetheless, the theory remains important to provide the background for its use as a tool for cross-country comparisons of income and wages, which is used by international organizations like the World Bank in presenting much of their international data.
- 6.2: The Consumer Price Index (CPI) and PPP
- The consumer price index (CPI) is an index that measures the average level of prices of goods and services in an economy relative to a base year. To track only what happens to prices, the quantities of goods purchased is assumed to remain fixed from year to year. This is accomplished by determining—with survey methods—the average quantities of all goods and services purchased by a typical household during some period.