What Is Purchasing Power Parity (PPP)?
Purchasing Power Parity compares what currencies can actually buy. Learn how it is used to assess exchange rate valuation.
Key Takeaways
- PPP states that exchange rates should equalise the price of identical goods across countries
- In practice, exchange rates diverge significantly from PPP for extended periods
- The Economist's Big Mac Index is a famous PPP benchmark
- PPP is more useful for long-run analysis than short-run trading decisions
The theory
Purchasing Power Parity states exchange rates between currencies should, in equilibrium, equalise the price of identical goods in different countries. If a basket of goods costs £100 in the UK and $130 in the US, PPP implies the exchange rate should be $1.30 per pound. If the actual rate is $1.20, the pound is undervalued relative to PPP.
The Big Mac Index
The Economist's Big Mac Index, published since 1986, uses the price of a McDonald's Big Mac in different countries to assess whether currencies are over or undervalued relative to the US dollar. The Big Mac is chosen because it is a standardised product made with locally sourced ingredients and locally paid labour in most countries.
Why PPP does not hold short-term
Exchange rates deviate substantially from PPP levels for years or decades. Reasons include: trade barriers that prevent arbitrage; non-traded goods in the price index; financial flows that overwhelm trade flows in determining short-term rates; and differences in productivity growth across economies. PPP is a long-run equilibrium concept, not a short-run predictor.
Practical uses of PPP
PPP is useful for: international GDP comparisons (the World Bank uses PPP-adjusted GDP to compare economic output fairly), long-run currency trend analysis, and evaluating market entry — assessing whether prices in a target market are realistic relative to local purchasing power.
PPP and business pricing
For a business selling into multiple international markets, PPP provides a useful framework for pricing. If your UK price is £50 and the PPP-implied Indian price is significantly lower than the market-rate equivalent, pricing for local purchasing power — even at lower nominal margin — often drives better volume and market penetration.