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October 1999, Vol. 122, No. 10
International price comparisons based on purchasing power parityMichelle A. Vachris and James Thomas
Imagine you are planning a trip to France and would like to figure out how much currency you will need during your visit. You would need to know how much in French francs it would cost for incidentals such as meals, sightseeing, and souvenirs. What information would be helpful to you in making your estimate? You could check the price of, say, a lunch in your hometown and then convert that figure into francs using the exchange rate. This type of estimate would not be very accurate, however, because it is likely that a lunch in your hometown costs relatively more or less than a lunch in France. A better estimate would be based on the price of a lunch in France.
Similarly, if you were opening a subsidiary company in Japan, how would you determine the salaries for your employees? Again, using the exchange rate to convert the salary you would pay in the United States into yen would not be accurate. To adequately compensate employees moving overseas, you would need information about the cost of living in Japan.
Finally, if a government or international organization were comparing national expenditures across different countries, merely collecting the gross domestic products (GDPs) of the countries and using exchange rates to convert them into a single currency would not yield an accurate comparison. Again, the comparison based on exchange rates does not take into account differing prices among the countries.
This excerpt is from an article published in the October 1999 issue of the Monthly Labor Review. The full text of the article is available in Adobe Acrobat's Portable Document Format (PDF). See How to view a PDF file for more information.
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