If you were to work and live in a foreign country, purchasing power parity (PPP) will help you calculate how much of the foreign country's currency would you need, to buy the same things you would in your own country with your domestic currency. Purchasing power parity, acronym: PPP.
Lets say you are a professional football player in Brazil and you get paid 10,000 reals a month; you have a decent house, a car, eat good food and also manage to spend on entertainment every week. You want to start a new life in Germany, a life which is more or less equal to the life you currently live in Brazil. Similar car, similar home, similar everything. How much should you earn every month in Germany? 1,580 euros a month (the market exchange rate)? Or 3,155 euros a month (the PPP exchange rate)? The answer is that you should earn 3,155 Euros per month in Germany in order to enjoy the same lifestyle that you do with 10,000 Brazilian Reals per month in Brazil. Try calculating it yourself.
Why is there a difference? 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 currency is in supply lower its price in the foreign exchange markets. Read here to know what triggers this demand and supply.
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.
Purchasing power parity was first conceptualized at the school of Salamanca and brought in its modern form by the Swedish economist Gustav Cassel. Read more here. Data on PPP is published and updated (extrapolated) by World Bank (for pretty much all countries) and OECD (for its member countries). There is also a debate on whether GDPs of different countries should primarily be expressed in PPP dollars rather than exchange rate dollars, because exchange rate conversions unfairly devalues the GDP contributions of some countries (such as India and China) and props up the GDP numbers of some countries (such as the UK and EU countries).
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.
To sum up, you use market exchange rates for imports and exports and use purchasing power parity for comparing incomes and living standards.
