Purchasing Power Parity

The theory of purchasing power parity (PPP) states that exchange rates are determined by the relative prices of an identical basket of goods. Changes in inflation rates should be offset by equal but opposite changes in the exchange rate. A classic example is the hamburger: if a hamburger costs $2.00 in the U.S. and £1.00 in the U.K., then according to PPP, the exchange rate must be $2 per £1. If the prevailing market exchange rate is $1.7 per £1, then the pound is considered an undervalued currency, while the dollar is considered overvalued. The theory assumes that these two currencies will eventually move toward a 2:1 relationship.

The primary limitation of PPP is that it assumes goods can be freely traded without considering transaction costs such as tariffs, quotas, and taxes. Another limitation is that it only applies to goods and ignores services, which can have significant differences in value. Additionally, besides inflation and interest rate differentials, several other factors influence exchange rates, such as economic data releases, asset markets, and political developments. Before the 1990s, PPP lacked empirical evidence to support its validity. After the 1990s, the theory appeared to hold only over long cycles (3–5 years). Over such timeframes, prices eventually converge toward parity.