Purchasing Power Parity

Why comparing incomes across countries using market exchange rates can mislead, and how purchasing power parity adjusts for different price levels.

Suppose you want to compare incomes in India and the United States. You could convert rupees to dollars using the market exchange rate. But this can be misleading, because many goods and services cost much less in India than in the United States. Purchasing power parity, or PPP, adjusts for these differences.

The idea

PPP asks: how much would it cost to buy the same basket of goods and services in each country? If a basket costs 100 dollars in the United States and the equivalent of 25 dollars at market exchange rates in India, then a rupee buys much more in India than the market exchange rate suggests.

PPP exchange rates are calculated by the International Comparison Program, coordinated by the World Bank, which compares prices of thousands of products across countries.

Why it matters

Using PPP changes the picture dramatically:

Country size: at market exchange rates, India’s economy is among the world’s five largest. Measured in PPP terms, it is the third largest, after China and the United States.
Living standards: incomes per person in poorer countries look much higher in PPP terms, because local prices are lower.
Poverty lines: the World Bank’s international poverty line, updated to 3 dollars a day in 2025, is measured in PPP dollars, so it reflects what money can buy locally.

Why prices differ

Services like haircuts, restaurant meals and domestic help are much cheaper in poorer countries, largely because wages are lower. Traded goods, like smartphones, tend to have more similar prices. This pattern is known as the Balassa-Samuelson effect.

The haircut test

A haircut might cost 150 rupees in a small Indian town, less than 2 dollars at market exchange rates, while a similar haircut in a U.S. city might cost 30 dollars. Converting an Indian income to dollars at market rates ignores that it buys many more haircuts. PPP accounts for this.

Limits

PPP estimates rely on comparing similar products, which is hard when quality and consumption patterns differ. Estimates are revised when new price surveys are done, sometimes changing country rankings.

Thinking PPP and market exchange rates measure the same thing

Market exchange rates matter for trade and international payments. PPP matters for comparing living standards and real economic size. Each is useful for different questions.

Key takeaways

PPP adjusts for different price levels when comparing countries.
The World Bank's International Comparison Program calculates PPP exchange rates.
In PPP terms, India is the world's third-largest economy.
Services are cheaper in poorer countries, so PPP raises their measured incomes.