Purchasing Power Parity (PPP)

Purchasing Power Parity (PPP) is a lens through which we can understand the real value of money across borders.

Imagine walking into a bakery in Tokyo and buying a loaf of bread for ¥500, then doing the same in New York for $5.

At first glance, comparing these prices seems pointless.

But PPP asks: How much “economic power” does each currency hold in its local context?

This concept helps economists, travelers, and global businesses cut through exchange rate noise to see what money can actually buy.

PPP is also important for currency traders because it helps identify long-term currency misalignments. It provides a fundamental baseline for understanding whether a currency is overvalued or undervalued relative to its real purchasing power.

Key Takeaways – Purchasing Power Parity (PPP)

• What Is PPP?
  • Purchasing Power Parity (PPP) is an economic concept that compares the relative value of currencies by measuring how much a basket of goods and services costs in different countries, adjusting for exchange rates.
• PPP Helps Spot Overvalued & Undervalued Currencies
  • Traders use PPP to understand whether a currency is mispriced relative to its real purchasing power. 
  • If the market exchange rate significantly deviates from the PPP rate, it may indicate an overvalued or undervalued currency
  • As such, it can be useful for long-term forex positioning.
  • We give examples or PPP under/overvaluation below.
• Inflation Drives Currency Depreciation (Relative PPP)
  • Higher inflation erodes purchasing power, which causes a currency to weaken over time.
  • Traders tracking inflation differentials (real rate differentials) can anticipate exchange rate shifts and hedge against currency devaluation risks.
• PPP is a Long-Term Indicator, Not a Trading Signal
  • Short-term FX movements are driven by factors like speculation, interest rates, and market sentiment, while PPP reflects long-term value. 
  • Use it to understand macroeconomic trends rather than for day-to-day trades.
• Non-Tradable Goods Distort PPP Accuracy
  • Goods like real estate and services don’t trade internationally, causing price disparities.
  • This limits PPP’s precision in forecasting exchange rates.
  • It’s one of many metrics to consider rather than a sole decision-maker for currency traders.

Why PPP Matters in a Globalized World

In an era where a smartphone app can instantly convert dollars to euros or pesos, exchange rates dominate conversations about international trade.

But exchange rates often reflect speculative market movements, not the true cost of living.

PPP strips away speculation, focusing instead on tangible goods and services. It answers questions like:

• Why does a haircut cost $20 in Chicago but ₹300 in Mumbai?
• How can a dollar stretch further in Vietnam than in Switzerland?

Focusing on purchasing power, PPP reveals hidden economic realities that raw currency conversions miss.

The Theory Behind PPP: More Than Just a Math Problem

Absolute PPP: The “Law of One Price”

At its core, PPP hinges on the “Law of One Price”: identical goods should cost the same everywhere when priced in a common currency.

For example, if a pair of sneakers costs $100 in the US and £80 in the UK, the exchange rate should adjust to 1.25 USD/GBP to equalize prices.

But reality is messier. Taxes, transportation costs, and regional preferences distort prices.

Absolute PPP assumes frictionless trade – a world without tariffs, shipping delays, or cultural biases.

While this ideal rarely holds, it sets a baseline for understanding currency valuation.

Relative PPP: Accounting for Inflation

Relative PPP introduces dynamism by factoring in inflation.

It states that exchange rates should adjust to offset differences in inflation rates between countries.

Suppose Mexico’s inflation is 6% annually, while Canada’s is 2%.

Over time, the Mexican peso should depreciate against the Canadian dollar by roughly 4% to maintain parity.

This principle helps explain long-term currency trends.

For instance, countries with hyperinflation (like Venezuela) see their currencies plummet not just due to market panic but because their purchasing power erodes faster than others.

This is also why certain types of assets like gold and precious metals are valued by some in a portfolio.

Because they act as a currency that’s nobody’s liability and effectively serve as a type of inverse to the price level (i.e., protection against currency devaluation).

PPP in Practice: How Economists Use It

Comparing GDP Across Nations

GDP measures economic output, but comparing the GDP of India and Germany ignores cost-of-living differences.

PPP-adjusted GDP recalculates these figures using local price levels.

By this metric, India’s GDP jumps to over that of Germany, reflecting its lower prices for goods and services.

This adjustment is why China’s economy appears larger than the U.S. in PPP terms—even if its nominal GDP lags.

Setting Exchange Rate Benchmarks

As covered in more depth here, central banks and investors use PPP as a guiding metric to assess whether a currency is overvalued or undervalued.

For example, if the PPP exchange rate for the euro is 1.10 USD/EUR but the market rate is 1.20, the euro might be considered overpriced.

This may better inform decisions about foreign investment or currency hedging.

Examples of PPP

Example 1: Big Mac in the US vs. Japan

• Price in the US = $5.50
• Price in Japan = ¥450
• Market Exchange Rate: 1 USD = 145 JPY
• Implied PPP Exchange Rate = 450 JPY / 5.50 USD = 81.82 JPY per USD
• Analysis – The actual market exchange rate (145 JPY/USD) is much weaker than the implied PPP rate (81.82 JPY/USD), suggesting that the Japanese yen is undervalued against the US dollar. In other words, it should rise to make it commensurate with the price of actual goods and services (in this case, a hamburger).

Example 2: Coffee in Switzerland vs. India

• Price in Switzerland = 5.00 CHF
• Price in India = ₹150
• Market Exchange Rate: 1 CHF = 95 INR
• Implied PPP Exchange Rate = 150 INR / 5 CHF = 30 INR per CHF
• Analysis – The actual exchange rate (95 INR/CHF) is much stronger than the implied PPP rate (30 INR/CHF), suggesting that the Swiss franc is overvalued against the Indian rupee. So, because the item is 30 INR per CHF in the real economy, but the exchange rate is 95 INR/CHF, the INR should rise/CHF should fall.

The Limitations of PPP: Where the Theory Falls Short

Reality is more complex, so PPP is only an approximate baseline.

Non-Tradable Goods and Services

PPP struggles with goods that can’t be easily exported, like real estate or haircuts.

A Manhattan apartment costs millions not because of currency values but due to limited supply relative to the demand.

Similarly, labor-intensive services (e.g., restaurant meals) vary widely in cost due to local wages, not exchange rates.

Market Imperfections and Trade Barriers

Tariffs, quotas, and transportation costs create price disparities.

A bottle of French wine may cost 30% more in Japan due to import taxes, even if the yen’s PPP suggests otherwise.

Similarly, agricultural subsidies in the EU keep bread prices artificially low compared to global markets.

Cultural Preferences and Consumption Patterns

PPP relies on comparing identical baskets of goods, but preferences differ globally.

Rice is a dietary staple in Asia, while Europe consumes more wheat.

Adjusting for these differences is subjective.

As such, it leads to debates about which goods to include in PPP calculations.

Case Study: The Big Mac Index

A Delicious (But Flawed) PPP Tool

Introduced by The Economist in 1986, the Big Mac Index simplifies PPP by using McDonald’s iconic burger as a universal product.

If a Big Mac costs $5.50 in the US and £4 in the UK, the implied PPP exchange rate is 1.38 USD/GBP.

Comparing this to the market rate highlights currency misalignments.

For example, recently the index showed the Swiss franc was 20% overvalued against the dollar, while the Turkish lira was 60% undervalued.

Why the Big Mac Isn’t Perfect

Local factors skew the index:

• Labor costs – Wages for McDonald’s workers vary globally.
• Ingredients – Some countries import beef, raising prices.
• Cultural perceptions – In India, where beef is taboo, the Maharaja Mac (chicken) replaces the Big Mac.

Despite its quirks, the index remains a relatable introduction to PPP.

PPP and Global Policy: Shaping Economic Decisions

Adjusting Foreign Aid and Poverty Lines

Organizations like the World Bank use PPP to set poverty thresholds.

The international poverty line is $2.15/day (PPP-adjusted using 2017 prices), reflecting the amount needed to buy basic goods in low-income countries.

Without PPP, comparing poverty rates across nations would be meaningless.

Informing Currency Manipulation Debates

Countries accused of keeping their currencies artificially weak (e.g., China in the 2000s) face scrutiny under PPP frameworks.

A significantly undervalued currency makes exports cheaper, fueling trade surpluses.

PPP helps policymakers identify imbalances that could lead to trade wars.

Variations of PPP

PPP isn’t a one-size-fits-all concept. Economists have developed nuanced variations to address real-world complexities.

Here’s a breakdown of key adaptations:

Absolute vs. Relative PPP

Absolute PPP relies on the Law of One Price, assuming identical goods should cost the same globally after currency conversion.

It’s a static snapshot but rarely holds due to trade barriers and taxes.

Relative PPP is dynamic, as it focuses on changes in exchange rates and inflation over time.

If Country A’s inflation outpaces Country B’s by 3%, its currency should depreciate by 3% to maintain parity.

This explains long-term currency trends but falters during economic shocks.

Tradable vs. Non-Tradable Goods PPP

Tradable goods (e.g., electronics, oil) usually align closely with PPP theory because they’re easily shipped.

A laptop’s price in Seoul and Sao Paulo converges due to global competition.

Non-tradable goods (e.g., haircuts, rent) defy PPP.

A Tokyo apartment might cost 10x more than one in Jakarta because land isn’t exportable.

This split explains why PPP often underestimates living costs in wealthy cities.

Sector-Specific PPP

Some analysts apply PPP to individual sectors. For example:

• Healthcare PPP – Comparing the cost of a MRI scan ($1,200 in the US vs. $150 in Thailand) reveals disparities in medical pricing.
• Technology PPP – Adjusting software subscription prices for regional incomes (e.g., Netflix charging $7/month in India vs. $15.50/month in the US).

The Balassa-Samuelson Effect

This variation explains why richer countries have higher price levels.

Workers in high-productivity economies (e.g., Germany) earn more, raising wages and prices for non-tradable services (like dining out).

PPP adjustments often overlook this, making poorer nations appear cheaper than they are.

Behavioral PPP

Incorporating psychology, this model acknowledges that consumers perceive value differently.

A $5 coffee in Zurich feels normal, but the same price in Hanoi seems exorbitant.

This can alter spending habits and distort PPP calculations.

The Starbucks Index

As a modern twist on the Big Mac Index, this compares the price of a latte globally.

A tall latte might cost $8 in New York but the equivalent of $4.90 in Seoul, hinting the Korean won was overvalued (i.e., it can buy more of the same good than the dollar can).

PPP for Digital Nomads

Remote workers use informal PPP by comparing Airbnb/hotel rates, meal costs, and coworking spaces across countries.

A $2,000/mo salary stretches further in Bali (low PPP-adjusted costs) than in London (high PPP-adjusted costs).

Why Variations Matter

These adaptations make PPP versatile, whether analyzing inflation gaps, setting fair wages for global teams, or explaining why your salary feels different abroad.

No single model is perfect, but together they paint a clearer picture of how money works in an unequal world.

The Future of PPP? Technology and New Challenges

Digital Currencies and PPP

Cryptocurrencies like Bitcoin operate outside traditional exchange rate systems.

Could PPP apply to decentralized digital money?

If a Bitcoin buys 5,000 coffees in Brazil but 2,500 in Norway, does that imply a “PPP ratio” for crypto?

Real-Time Data and Machine Learning

Historically, PPP calculations relied on periodic surveys.

Today, AI models predict price and PPP adjustments faster than before.

Conclusion: PPP as a Bridge Between Economies

Purchasing Power Parity isn’t a flawless theory, but it’s one way to help make sense of our interconnected world.

From adjusting GDP to explaining why your vacation budget stretches further in Bali than Paris, PPP reminds us that money’s value lies in what it can do – not just its nominal amount.