What Determines Purchasing Power Parity Exchange Rates? - Working Paper 416

To provide a better understanding of the large variation in price levels between countries, we report on a cross-country analysis of national price levels, using Purchasing Power Parity (PPP) data on 168 economies from the most recent 2011 International Comparison Program (ICP). PPPs are used for many purposes, including to set international poverty lines and allocate IMF quotas. The well-known Balassa-Samuelson income effect is not the only factor affecting PPPs. Particularly for low and middle income countries, our results indicate that structural and policy factors make a difference. We cover a wide range of factors that affect PPP exchange rates (geography, aid inflows, good governance, subsidy programs, open labor market policies, level of inequality) and, finally, confirm the relationship between low PPP price levels and greater competitiveness in manufactures, especially for low and middle income countries.