Purchasing Power Parity (PPP)
Plain definition
The theory that exchange rates should adjust so identical baskets of goods cost the same in different countries. In absolute PPP, the exchange rate equals the ratio of price levels; relative PPP says the rate should move with inflation differentials.
In economics
PPP is the benchmark behind the Big Mac Index and behind GDP comparisons adjusted for price differences -- which is why China's PPP-adjusted GDP exceeds its market-exchange-rate GDP. Absolute PPP rarely holds because of transport costs, tariffs, and non-traded services, but relative PPP works better over long horizons.
Example
If an identical basket costs $100 in the US and 80 euros in the Eurozone, absolute PPP implies a rate of 1.25 dollars per euro. If the market rate is 1.10, the euro looks undervalued by this measure.
PPP is often mistaken for a claim that exchange rates track price levels exactly. In reality absolute PPP fails in the short run -- it is a long-run equilibrium benchmark, and deviations (from capital flows, speculation, sticky prices) can persist for years.