Purchasing power parity constitutes a very old and fundamental theory of economics. The basic idea is that a good or service should cost about the same in one economy as in another. When this doesn't happen it means that either one currency is overvalued or another undervalued. Economists take advantage of this law to observe distortions in markets from inflation and government interference. Observing imbalances in purchasing parity helps explain trade imbalances.
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Quality of Life
Discovering the difference between purchasing power in different economies helps scholars to observe differences in the quality of life. Even if the currency of a country has become severely devalued, it may not have very wide effects on the majority of citizens as long as their purchasing power remains near parity for domestic goods. Even if the currency fluctuates in the short term, purchasing parity hopefully remains over the long term.
Finding gross domestic product (GDP) provides a good general way to measure the wealth of different economies. Unfortunately, if an economist calculates GDP with the standard domestic currency rates, it can lead to an inaccurate picture. Experts often point to the example of China, which intentionally devalues its currency. By adjusting for the assumed purchasing parity that China has with the United States, economists can provide a more accurate idea of the nation's wealth.
Correcting Trade Imbalances
When a severe trade imbalance develops between a nation's exports and its imports, economists may propose a variety of remedies. A common proposal is to erect trade barriers which may further distort markets. If, however, economists can observe a difference between a nation's purchasing power and its currency rate, the imbalance becomes much simpler to correct. Readjusting the currency to match actual purchasing power can solve the problem without excessive government involvement.
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