Purchasing Power Parity: What PPP Says About Exchange Rates

A traveller changes money at the airport, orders a coffee in the arrivals hall and does the sum in their head. Either it feels cheap or it feels like robbery. That instinctive comparison, between what money buys at home and what the same money buys once converted, is the starting point of purchasing power parity, usually shortened to PPP.

The idea in one paragraph

Purchasing power parity says that, over time, exchange rates should move towards the level at which a basket of identical goods costs the same in two countries once prices are converted. If a basket costs 100 in one currency and 150 in another, the "PPP rate" between them would be 1 to 1.5. When the market rate sits well away from that figure, one currency is said to be undervalued or overvalued on a PPP basis.

Two versions of the theory

• Absolute PPP compares price levels directly: the same basket should cost the same everywhere after conversion. It is the version behind most price-comparison indexes.
• Relative PPP looks at changes rather than levels. It says the currency of a country with higher inflation should tend to lose value against one with lower inflation, by roughly the difference between the two inflation rates. Inflation's place among the other forces is covered in what affects exchange rates.

The burger version

The best-known illustration takes a single fast-food burger, sold in a near-identical form in many countries, and treats its local price as a tiny basket. Dividing one country's burger price by another's gives an implied exchange rate, which can then be set beside the market rate. The Big Mac index is light-hearted by design, yet it makes the concept easy to grasp, and it shows the problem with taking PPP too literally: a burger's price includes rent, wages and local taxes, none of which can be shipped across a border.

The numbers are made up to show the arithmetic, not taken from any real comparison.

Why market rates drift away from PPP

Exchange rates can stay far from their PPP level for years. The main reasons are practical rather than mysterious:

1. Many things cannot be traded. Haircuts, housing and restaurant service are priced locally. Wages in richer countries tend to push these prices up, so poorer countries usually look cheap on a PPP basis.
2. Trade has costs. Shipping, tariffs and regulation stop prices from evening out even for goods that can move.
3. Money flows outweigh trade flows. Investment and interest-rate differences can move a currency far more than the price of goods. The mechanism is set out in how interest rate decisions affect exchange rates.
4. Some rates are managed. A currency held at a fixed level by its central bank can sit away from PPP for as long as the policy lasts, as described in floating vs fixed exchange rates.

Where PPP is genuinely useful

Its main job is comparison rather than prediction. International organisations convert national income figures at PPP rates so that living standards can be compared without daily currency swings distorting the picture. Economists use deviations from PPP as one rough sign of whether a currency looks stretched over a long horizon. Salary and cost-of-living comparisons between countries often rely on PPP-style adjustments too. For anyone weighing an overseas purchase, the gap between local prices and the converted rate is part of the picture, alongside the currency risk discussed in exchange rate risk when buying property abroad.

What PPP cannot tell you

It does not say when a gap will close, or whether it will close at all. A currency that looks undervalued can become more undervalued. Treating PPP as a timing tool for currency trades ignores everything listed above, and the theory itself makes no claim about weeks or months.

A general explanation of an economic concept, not a forecast or investment advice. For decisions about money in another currency, a qualified adviser can look at your circumstances.