At the time of writing this article, the exchange rate of dollar to rupee is approximately equal to Rs.76. So, if a person earns $25,000 per annum (p.a) in the US, their salary in rupees would be around Rs. 19 lakh p.a. A salary of Rs. 19 lakh p.a would place a person in the high-income category in India, whereas $25,000 p.a falls into the lower-middle-class category of income in the US. Why does this disparity exist between the two cases? It might have to do with how we perceive the value of money itself.
This is a cognitive bias of money illusion and is typically the result of not taking inflation into account. However, this concept can be extended and applied to differences arising out of variations in currency exchange rates as well. In the above example, one begins with the understanding that the value of $1 in the US is the same as the value of Rs.76 in India. Exchange rate conversions do not take into account the purchasing power of a particular currency in a country. It is not useful for international comparisons. Hence, it is not a good indicator of one’s economic strata or standard of living as seen from the above example. That is why another indicator called purchasing power parity (PPP) is used.
Purchasing power parity is a theoretical exchange rate. It is used to compare the purchasing power of various currencies in the world. The calculation of PPP is done in three stages. The first stage is a basic comparison at the product level; a certain product is chosen which is sold in many countries in their respective currencies. One of the most well-known indices of this type is the Big Mac index, invented by the Economist magazine in 1986. This index analyses PPP in a lighter vein and is termed as the magazine’s ‘interactive tool’ to analyze currency fluctuations. It compares the price of the big mac burger by McDonald’s in various currencies and makes it easier to comprehend. A Big Mac (the equivalent of Chicken Maharaja Mac) costs Rs. 205 in India and $5.67 in the United States (January 2020). The implied exchange rate or the PPP adjusted exchange rate is obtained by taking the ratio of the two prices i.e. Rs 36 per dollar. The difference between this computed exchange rate and the actual market exchange rate is Rs. 40 (76-36). The subsequent stages in the calculation of PPP follow a more involved process of considering weighted averages of a basket of goods and services. These weighted averages are then compared to arrive at the official value of PPP.
How does this cognitive bias manipulate perception?
The salary packages offered to students of coveted business schools like IIMs (Indian Institute of Management) are hefty. Some of the highest packages are offered by MNCs not based in India and this salary is dollar-denominated. At IIM-Ahmedabad, the average international salary is $ 80,050 and its rupee equivalent is around 57 lakh per annum, whereas the average domestic salary is around Rs.26 lakh. The international average salary is more than double the average domestic salary. As seen in the earlier example, multiplying the salary by the exchange rate is often not a good indicator for comparison. Thus, comparisons between dollar-denominated salaries from MNCs and salary packages paid out by Indian companies might be falling prey to money illusion.
Let us assume that this is the salary of a person who would be working in the US. A salary earned in dollars in the US would be spent in the US itself. Hence, converting the salary amount from dollars to rupees has little relevance. Exchange rate conversions are only relevant if the money is going to cross borders and be spent in the currency it has been converted to.
To understand which salary is higher, the dollar-denominated salary needs to be converted to rupees using the PPP adjusted exchange rate. The PPP exchange rate of rupee to USD is $18.1 as of 2018. Multiplying the dollar amount of the salary ($ 80,500) by the PPP exchange rate amounts to around Rs.15 lakh. The average domestic salary is around Rs.26 lakh. So, it turns out that the average Indian package is higher than the average international package in real terms.
Application of PPP:
PPP is also used to calculate other macroeconomic indicators such as GDP, national income, per capita income which are computed at the national level. The following graphs compare nominal values and PPP adjusted values of India’s GDP and GDP per capita as of 2018.
Source for fig 1 and 2: World bank
There is a significant disparity between the nominal values and the PPP adjusted values. For India, the ratio of PPP adjusted GDP to nominal GDP is nearly 4:1. This is a characteristic of developing countries where fiscal policy is dominant and the government uses it as a welfare measure. In such countries, subsidies are a major component of government expenditure. These subsidies are usually for basic necessities such as food, transport, health, and education. Due to these subsidies the prices are not determined solely by market forces and tend to be lower. The presence of a large informal sector is also common in these countries. Welfare measures, such as the Minimum Wage Act, do not apply to this informal economy, leading to substantially lower wages. Hence, the relative purchasing power increases due to government subsidies and the availability of cheap labour.
Even though the official exchange rate is determined by the market forces, government control over the domestic economy distorts the market prices. This is reflected in the PPP adjustment of exchange rates.
Gayatri Ganpule
