While market exchange rates and purchasing power parity (PPP) are both methods to evaluate and compare currencies. Their purposes are uniquely different. You use market exchange rates if you are exporting or importing stuff; or planning a foreign holiday (which is akin to an import). You use purchasing power parity to calculate how much money would you need in another country in that currency to enjoy a certain lifestyle.
Market exchange rates are determined by the demand and supply of different currencies. The more a currency is in demand the greater its price, the more a central bank prints currency the lower its price in the foreign exchange markets. Primary drivers of value of a currency are:
- Export and imports. The more you export higher the demand for your currency, because exporters seek payment in their own currency. On the contrary if you import you are using more of a foreign currency than your own.
- Interest rates. Higher the interest rates higher the likelihood that the currency will be retained by locals as savings. Hence making it dearer in the the international market.
- Inflation. Higher the inflation in a country lower the value of its currency. Read more about inflation.
- Units of currency printed. The more a central bank prints currency the more easily available it is in the international market. Hence it making it cheaper.
- Political stability / instability. Currencies of politically unstable countries are valued extremely low. Principally because a currency is paper that stands on the guarantee of the government. If the government is shaky then the currency isn't worth much.
- Domestic growth. The more a country grows the more it produces and consumes internally. It also (generally) improves its position in the global market as an exporter (like China and India have in recent years) hence making its currency worth more.
- Government debt. If the government has high debt and is unable to pay its debt, it will either take new debt to pay old debt; hence reduce the value of its currency, or it will print more currency, which again reduces the value of a currency.
and the list goes on.
[Quite interestingly countries that have enmities have tried to destabilize each other by smuggling counterfeit currency to their enemy county in hopes to devalue their enemy's currency and hence destabilize the enemy country.]
Essentially market exchange rate is the price of your currency for foreigners, it has noting to do with the quality of life you enjoy with the money you earn. This is exactly the reason why using market exchange rates make sense if you wish to import something or are planning a holiday abroad. But it makes no sense if you plan to settle abroad or simply wish to compare your income across different countries.
In comes purchasing power parity.
PPP derives its exchange values from how much local currency would you need in a country to purchase stuff like food, housing, transport, entertainment, medical services, legal services, education, the list goes on to around 3000 consumer goods, 30 government occupations, 200 equipment goods and 15 types of construction projects; everything that goes into computation of GDP (read more here). This value is derived for (almost) the same 3245 goods and services for each country. After this is done you can now compare how much money would you need in local currency to buy stuff in this country vs that country vs another country vs yet another country. For the same reason Purchasing Power Parity is the method of choice if you wish to compare your income in your country with your target income in another country.
Approaching price comparison by PPP method is desirable because it factors in the differences in resource availability (hence price differences) in different countries. For instance seafood is cheap in coastal countries but comes at a premium in inland countries. Pineapples are cheap and of good quality in Costa Rica and Côte d'Ivoire (you will need CRC 137, 075.18 to buy the same things you do with XOF 100,000 in Côte d'Ivoire) but are relatively expensive in the USA. To sustain a living one consumes a fairly large mix (basket) of goods and services rather than just one good. Hence it becomes important to evaluate prices across the spectrum of 3245 goods and services (unlike the big mac index which is based on just one product) so that such price polarities are accounted for. So while real-estate might be expensive in one country, it might be offset by an inexpensive healthcare system.
It is this difference between exchange rate and purchasing power parity that when tourists from USA, UK and EU nations travel to Africa, South America and East Asia, they suddenly find themselves being able to afford a lot more stuff with their Dollars and Euros and Pounds. And on the contrary, tourists from Asia, South America and Africa find travelling to America and Europe an expensive proposition even if they earn and enjoy fairly high standards of living in their own country.
To sum up, market exchange rates for export and import and purchasing power parity for comparing incomes and living standards.
