Purchasing Power Parity
Purchasing Power Parity (PPP) is an economic theory and measurement framework that compares the relative value of different currencies by equalizing the prices of an identical basket of goods and services across countries.
Purchasing Power Parity rests on the law of one price: in frictionless markets, identical goods should sell for the same price when expressed in a common currency. PPP extends this idea to the aggregate price level — if a basket of goods costs $100 in the United States and the same basket costs 7,400 Japanese yen in Japan, then the PPP exchange rate would be 74 yen per dollar. If the actual market exchange rate differs significantly from this PPP rate, one currency is considered overvalued or undervalued relative to PPP.
The Big Mac Index, published by The Economist since 1986, is a popular informal application of PPP that uses the price of a McDonald's Big Mac as the standardized basket. More rigorous PPP estimates are produced by the World Bank's International Comparison Program and the OECD, which periodically publish PPP-adjusted GDP figures for countries worldwide. These adjustments allow economists to compare living standards and economic output across countries in a way that accounts for differences in domestic price levels.
PPP is central to international macroeconomics for several reasons. First, it provides a benchmark for assessing currency misalignment — a currency trading far below its PPP rate is potentially undervalued and may eventually appreciate. Second, PPP-adjusted GDP figures provide a more accurate picture of economic size when price levels differ dramatically between countries. China's GDP, when measured at market exchange rates, is smaller than the U.S.; when adjusted for PPP, it is roughly comparable, reflecting China's lower price level.
However, PPP has well-known limitations. Transportation costs, trade barriers, non-tradable goods (such as haircuts and restaurant meals), and differences in product quality all cause persistent deviations from PPP. In practice, actual exchange rates can deviate from PPP estimates for years or even decades.
For U.S. equity investors with international exposure, PPP provides a long-run anchor for thinking about currency risk and the real value of foreign earnings when translated back into dollars.