Purchasing power parity (PPP) is an economic theory and a technique used to determine the relativevalue of currencies, estimating the

amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to (or on par with) each currency's purchasing power. It asks how much money would be needed to purchase the same goods and services in two countries, and uses that to calculate an implicit foreign exchange rate. Using that PPP rate, an amount of money thus has the same purchasing power in different countries. The idea originated with the School of Salamanca in the 16th century and was developed in its modern [2][3] form by Gustav Cassel in 1918. The concept is based on the law of one price, where in the absence of transaction costs and official trade barriers, identical goods will have the same price in different [4] markets when the prices are expressed in the same currency. Another interpretation is that the difference in the rate of change in prices at home and abroad the difference in the inflation ratesis equal to the percentage depreciation or appreciation of the exchange rate.

Functions[edit source | editbeta]

The purchasing power parity exchange rate serves two main functions. PPP exchange rates can be useful for making comparisons between countries because they stay fairly constant from day to day or week to week and only change modestly, if at all,from year to year. Second, over a period of years, exchange rates do tend to move in the general direction of the PPP exchange rate and there is some value to knowing in which direction the exchange rate is more likely to shift over the long run. Among other uses, PPP rates facilitate international comparisons of income, as market exchange rates are often volatile, are affected by political and financial factors that do not lead to immediate changes in income and tend to systematically understate the standard of living in poor countries, due to the Balassa Samuelson effect. An example of one measure of the law of one price, which underlies purchasing power parity, is the Big Mac Index, popularized by The Economist, which compares the prices of a Big Mac burger in McDonald's restaurants in different countries. The Big Mac Index is presumably useful because although it is based on a single consumer product that may not be typical, it is a relatively standardized product that includes input costs from a wide range of sectors in the local economy, such as agricultural commodities (beef, bread, lettuce, cheese), labor (blue and white collar), advertising, rent and real estate costs, transportation, etc. Although it may seem as if PPPs and the law of one price are the same, there is a difference: the law of one price applies to individual commodities whereas PPP applies to the general price level. If the law of one price is true for all commodities then PPP is also therefore true; however, when discussing the validity of PPP, some argue that the law of one price does not need to be true exactly for PPP to be valid. If the law of one price is not true for a certain commodity, the price levels will not differ enough from the [4] level predicted by PPP. The purchasing power parity theory states that the exchange rate between one currency and another currency is in equlibirium when their domestic purchasing powers at that rate of exchange are equivalent.