Reliability of PPPs

Anyone with some background in economics is probably familiar with the concept of Purchasing Power Parities (PPP). It is a special price index used to convert countries’ national accounts (in local currencies) into comparable terms (e.g. US dollar). But how are PPPs actually computed and how reliable are they?.

Purchasing power parities (PPPs) are compiled every 5 years or so (the last was in 2011) through the International Comparison Program (ICP), administered by the World Bank under the auspices of the Statistical Commission of the United Nations and with the collaboration of the OECD, EUROSTAT and other regional organisations. ICP uses a a sophisticated framework for compilation of PPPS outlined below (the graph is courtesy of Prasada Rao)

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In the first stage, national prices of similar items are aggregated (without weights) into around 200 “basic headings” using either the CPD or GEKS methods. At the second stage, PPPs at the basic heading level are aggregated upwards using the expenditure weights to the GDP level or other major aggregates where any of GEKS, weighted CPD, Geary-Khamis and Iklé methods can be used [for details see the World Bank (2013) especially the chapters by Rao and Diewert].

Despite the importance of PPPs and the sophisticated procedure, the reliability of PPP estimates is not known e.g. no standard errors or reliability measures are published by the ICP (see e.g. this for why this might be important). In this paper with Prasada Rao, we have proposed a (generalized) method of moment approach to PPP estimation which allows estimation of standard errors for almost all the indexes used in the literature. This paper outlines the general approach. In future works we go into further details with more realistic standard error estimates.

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