Purchasing Power Parity

What Is Purchasing Power Parity?

Purchasing power parity, or PPP, is the idea that exchange rates should tend to adjust over time so that an identical basket of goods costs the same across countries once prices are converted into a common currency. The core intuition is that if a good were much cheaper in one country, trade and arbitrage would push demand and exchange rates until the price difference shrank. A key implication concerns inflation: under PPP reasoning, the currency of a country with persistently higher inflation than its trading partners should depreciate against their currencies, offsetting the rising domestic prices. PPP is also used to compare living standards and economic size across countries more fairly than market exchange rates allow.

Why It Matters

Purchasing power parity is a benchmark rather than a precise short-run predictor. In reality, exchange rates can deviate from PPP for long stretches because many goods and services are not traded across borders, transport costs and trade barriers exist, and financial flows often dominate currency markets. The popular 'Big Mac index' illustrates PPP by comparing burger prices worldwide to gauge whether currencies look overvalued or undervalued. Despite its limitations, PPP is widely used: international organizations rely on PPP-adjusted figures to compare GDP and living standards, since market rates can understate the real buying power of incomes in lower-price countries. As a long-run anchor, PPP helps explain why high-inflation currencies tend to weaken over time.

Test Your Knowledge

Questions on this topic from the EconRecall fact bank:

• Under purchasing power parity reasoning, what should happen over time to the currency of a country with persistently higher inflation than its trading partners?
  It should depreciate against their currencies
• What is the core idea of purchasing power parity (PPP)?
  Exchange rates should tend to adjust so that an identical basket of goods costs the same across countries