Purchasing Power Parity (PPP) is a theory that says that in the long run (over several decades), the exchange rates between countries should even out so that goods essentially cost the same in both countries. The Purchasing Power Parity theory explains that there should be no arbitrage opportunities (where price differences in countries can result in profit). PPP is based on The Law of One Price which implies that all identical goods should have the same price. It is usually calculated using a similar basket of goods in two countries and is also used to evaluate under/overvalued currencies.
The basket of goods and services priced for the PPP exercise is a sample of all goods and services covered by GDP. The final product list covers around 3,000 consumer goods and services, 30 occupations in government, 200 types of equipment goods and about 15 construction projects. A large number of products is to enable countries to identify goods and services which are representative of their domestic expenditures.
Purchasing Power Parity Example
For example: A loaf of bread in the US costs $2, and that in Indian Rupees is 90, but a loaf of bread in India costs around 10, that’s about 20 cents. This creates an arbitrage opportunity where people in India can stock up on bread and bring it to the US and sell it and make a nice profit. Purchasing Power Parity says that since they are the same goods, the purchasing power in the countries should be the same. This doesn’t mean the exchange rate should be equal to one; it means the ratio of price to exchange rate should be one. In this example, it implies that exchange rate should be $2 = 10, $1 = 5. So, the Rupee here is undervalued.
The Real Exchange Rate
The Real Exchange Rate (RER) is a related topic to PPP, it calculates, for example, how many iPods in country A is equal to one iPod in country B. It usually is calculated with a basket of goods.
The Real Exchange Rate Formula
Real Exchange Rate = (nominal exchange rate) x (Price of the good X abroad/Price of good X at home)
For example, an apple in the US costs $1, and in Mexico 2 Pesos. The nominal exchange rate is, for example, $0.25 to a Peso. The real exchange rate would be = 0.25 x (2/1) = 0.50
This rate means that half an apple is the US is one apple in Mexico. This creates an arbitrage opportunity, but if the RER were 1, then we would have Purchasing Power Parity.