Handbook of Exchange Rates

6.5 Price Variable in PPP Computations

Crucial to empirical use and testing of PPP is the price concept, and many price concepts have been used in PPP computations. Ranging from most justifiable to least justifiable (with symbols), they are as follows: GDP deflator (PGDP), GNP deflator (PGNP), consumption deflator (PCONS), retail price index [incorporating consumer price index and cost-of-living index] (RPI), wholesale price index (WPI), export price index (XPI), wage-rate index (WI), component indexes or subindexes of WPI or RPI, and prices of individual commodities.

The bar separating PPP-legitimate price measures is drawn between WPI and XPI. So only results based on PGDP, PGNP, PCONS, RPI, and WPI are included in the survey. PGDP and PGNP have three justifications. First, as stated by Cassel (1930, p. 33), PPP relates to the internal value of currencies, and therefore should be “measured only by general index figures representing as far as possible the whole mass of commodities marketed in the country.” PGDP and PGNP fit this criterion better than any other price index. Second, PPP is a macroeconomic theory, and therefore necessitates the usual macro-price concept, PGDP or PGNP, with the former marginally preferred, because it measures the price of production within the country. Third, to the extent that PPP is justified by arbitrage and substitutability of commodities in production and consumption (broadly construed), the price concept underlying PPP should be as broad as ...