Comparisons of Price Levels Across Regions: Theory and Practice

This chapter discusses the theory and practice of regional price index numbers, particularly focusing on exchange rates and Purchasing Power Parity (PPP). The chapter begins by highlighting the limitations of using exchange rates for price comparisons due to their volatility and the Balassa–Samuelson effect, which causes market exchange rates to undervalue currencies of developing countries. It suggests using price indices to measure prices across countries, adapting the theoretical framework used for temporal comparisons to spatial ones. The concept of Purchasing Power Parity (PPP), introduced by Gustav Cassel in 1918, is discussed in depth. It emphasizes that while comparing prices between two countries using a basket of goods is straightforward, involving more countries complicates calculations due to non-transitivity issues. To address these complexities, the chapter introduces three main methods used for constructing PPP: Gini–Eltető–Kőves–Szulc (GEKS), Geary-Khamis (GK), and the Country Product Dummy (CPD). Each method has its strengths and weaknesses, with GEKS ensuring transitivity and GK satisfying aggregation consistency. The CPD method employs regression analysis to account for differences in goods across countries, making it suitable for international comparisons where homogeneous goods are difficult to find. The chapter also introduces the Minimum Spanning Tree (MST) method, which aims to reflect the “distance” between countries in price index calculations. Despite advancements, the chapter acknowledges the challenges in constructing accurate regional price indices, such as differences in consumption baskets and the quality of goods and services between countries. It concludes by highlighting the ongoing research and the importance of PPP for international economic comparisons.