Purchasing power parity
Family IX · Macro
Not to be confused with exchange rate, inflation rate, floating exchange rate.
Purchasing power parity (PPP) is a theory of exchange rate determination based on the law of one price. It holds that in the absence of trade barriers and transport costs, goods should cost the same everywhere when expressed in a single currency. PPP is used to compare living standards across countries and to assess whether a currency is over- or undervalued.
Absolute and relative PPP
Absolute PPP states that the exchange rate between two currencies equals the ratio of their price levels for an identical basket of goods. If a basket costs $100 in the United States and €80 in the euro area, absolute PPP implies an exchange rate of $1.25 per euro.
Relative PPP is a weaker form: it says that the percentage change in the exchange rate over time equals the difference in inflation rates between the two countries. Relative PPP does not require the law of one price to hold at a single point in time, only that deviations do not grow systematically.
Worked example: relative PPP
Suppose the United States has an inflation rate of 3% and the euro area has an inflation rate of 1% over a year. Relative PPP predicts that the euro will appreciate against the dollar by approximately the inflation differential.
If the current EUR/USD rate is 1.1000, relative PPP implies a rate of 1.1000 × (1 + 0.02) = 1.1220 after one year.
Limitations
PPP rarely holds exactly in the short run because of trade barriers, transport costs, differences in consumption baskets, and the presence of non-traded goods and services. Statistical agencies publish PPP-adjusted GDP figures to compare economic well-being, but these are estimates that vary by methodology and base year. Traders sometimes use PPP as a long-term anchor for currency valuation, but it is not a precise timing tool.
Often confused with
- exchange rate
- An exchange rate is the price of one currency expressed in units of another, determined in foreign-exchange markets and used to convert values between the two monetary areas.
- inflation rate
- The inflation rate is the percentage change in a price index, typically a consumer price index, over a specified period, usually a year, measuring how much the general level of prices has risen or fallen.
- floating exchange rate
- A floating exchange rate is a currency regime in which the market determines a currency's value against other currencies through supply and demand, without a fixed peg or a predetermined target band maintained by the central bank.