Intermediateinternational trade
Purchasing Power Parity: What Currencies Should Be Worth
Overview
Purchasing Power Parity (PPP) is one of international economics' most elegant ideas: in the long run, exchange rates should adjust so that a basket of goods costs the same everywhere. If a burger costs $5 in the US and ¥750 in Japan, the 'PPP rate' is ¥150 per dollar — and deviations flag over- or undervaluation. This lesson builds PPP from the law of one price, introduces absolute and relative PPP, tours the evidence (it works poorly short-term, better long-term), and shows its practical uses from the Big Mac index to GDP comparisons.
Learning objectives
- State the law of one price and derive absolute PPP
- Distinguish absolute from relative PPP
- Interpret the Big Mac index
- Explain why PPP fails short-term: transport, tariffs, non-tradables
- Use PPP for GDP comparisons and valuation calls
The law of one price
Start with one good: absent transport costs, tariffs, and barriers, an identical good should sell for the same price everywhere once converted to a common currency — otherwise arbitrageurs would buy low and sell high until prices converged. If wheat is , it should cost ¥30,000/ton in Japan. Persistent gaps invite 'buy cheap here, sell dear there' trades that close them. This is the micro-foundation: PPP simply applies the law of one price to entire baskets of goods instead of single items.
PPP rests on arbitrage — riskless profit from price gaps. Where arbitrage is blocked (haircuts can't be shipped), the law of one price fails and PPP weakens.
Absolute and relative PPP
Absolute PPP says the exchange rate equals the ratio of national price levels: S = P_domestic / P_foreign. If US prices double relative to Japan's, the dollar should halve against the yen. Relative PPP is the weaker, more useful claim: the change in the exchange rate equals the inflation differential. With 6% US inflation and 2% Japanese inflation, the dollar should depreciate about 4% yearly against the yen. Relative PPP sidesteps the impossible task of comparing identical baskets — it only needs inflation rates — and it is the version economists actually test.
Relative PPP: %ΔS ≈ π_domestic − π_foreign. A country with persistently higher inflation should see its currency depreciate at roughly the inflation gap.
The Big Mac index
The Economist's lighthearted PPP gauge prices the Big Mac — a fairly standardized product sold worldwide — in local currency and converts at market rates. If a Big Mac costs ; with the market at £0.79/$, sterling looks about 4% undervalued. The index is pedagogical, not a trading system: burgers include non-tradable inputs (rent, wages) that shouldn't equalize, and McDonald's pricing reflects local strategy. Still, it communicates PPP intuition better than any equation, and its long time series is genuinely informative about persistent misalignments.
Why PPP fails in the short run
Four frictions break it. Transport costs and tariffs wedge prices apart. Non-tradable services (housing, haircuts, local labor) dominate consumer baskets and never face arbitrage. Pricing-to-market: firms deliberately charge different prices in different countries based on local competition. And capital flows swamp trade flows: trillions in daily forex turnover chase interest differentials and risk sentiment, pushing rates far from PPP for years. The evidence: PPP has almost no predictive power month-to-month, but real exchange rates do revert toward PPP over 3–5 year horizons — 'PPP holds in the long run' is the profession's cautious verdict.
Studies find PPP deviations decay with a half-life of 3–5 years — glacial by trading standards. PPP is a long-run anchor, not a forecast.
PPP in practice: GDP comparisons and valuation
PPP's biggest practical job is comparing living standards. Converting GDP at market exchange rates understates poor countries' output because their non-tradables are cheap; PPP conversion corrects this — India's PPP GDP is several times its market-rate GDP. The IMF and World Bank publish PPP GDP tables on this basis, which is why China ranks as the world's largest economy in PPP terms while the US leads at market rates. Investors also use PPP deviations as contrarian valuation signals: deeply undervalued currencies (per PPP) have historically offered higher subsequent returns — over multi-year horizons, with plenty of patience required.
Key points
- PPP: exchange rates should equalize price levels across countries (law of one price for baskets).
- Relative PPP (inflation differentials drive currency moves) is the testable version.
- The Big Mac index makes PPP intuitive using a standardized global product.
- PPP fails short-term on transport costs, non-tradables, and capital flows — but anchors the long run.
- PPP GDP comparisons correct the understatement of poor countries' output.
Common misconceptions
✓ Truth: PPP deviations persist for years; it is a long-run equilibrium concept with 3–5 year half-lives, useless for short-term forecasting.
✓ Truth: It flags deviations from a burger-based benchmark, but burgers embed local wages and rents that legitimately differ — deviation is not proof of manipulation.
✓ Truth: They systematically differ: PPP raises poor countries (cheap non-tradables) and lowers rich ones. Both measures answer different questions.
Practice questions
Q1. A Big Mac costs $5 in the US and €4 in the eurozone. The PPP-implied rate is €0.80/$. If the market rate is €0.90/$, the euro is:
- Overvalued by about 12.5%
- Undervalued — it should buy more dollars than it does
- Correctly valued
- Impossible to judge
PPP says €0.80 buys $1; the market demands €0.90 per dollar, so the euro buys fewer dollars than PPP implies — it is undervalued against the dollar on this measure.
Q2. Relative PPP predicts that if US inflation is 5% and eurozone inflation is 2%, the dollar should:
- Appreciate about 3% against the euro
- Depreciate about 3% against the euro
- Stay exactly fixed
- Appreciate 7%
%ΔS ≈ π_domestic − π_foreign = 5% − 2% = 3% depreciation of the dollar. Higher inflation erodes the currency's purchasing power, and the exchange rate adjusts.
Q3. The main reason PPP fails for services like haircuts is:
- They are too cheap to matter
- They are non-tradable — no arbitrage can equalize their prices across countries
- Governments fix their prices
- They use no imported inputs
You cannot ship a haircut from Mumbai to Manhattan to arbitrage the price gap. Non-tradables, which dominate consumer baskets, break the law-of-one-price logic PPP needs.
Click a question to reveal the answer and explanation.
Frequently asked questions
What is the Balassa-Samuelson effect?
The theory that fast-growing countries see real appreciation because productivity gains concentrate in tradables, pushing up wages and non-tradable prices economy-wide. It explains why rich countries have higher price levels — the Penn effect.
How is PPP GDP actually calculated?
The International Comparison Program collects prices for hundreds of comparable goods and services across countries, builds PPP conversion factors, and applies them to GDP. It is a massive statistical exercise run every few years.
Does PPP apply to gold?
Gold approximately follows a law of one price globally since it is tradable and standardized. Persistent gaps across markets are quickly arbitraged away by dealers.
Why do economists still teach PPP if it fails empirically short-term?
Because it is the benchmark everything else is measured against — monetary models nest PPP as the long-run anchor, and persistent deviations are themselves informative about frictions and risk premia.