Anyone who has been on holiday has a rough sense of whether a currency feels cheap or expensive. A coffee in one city costs a fortune, while in another it seems almost free. Purchasing power parity, usually shortened to PPP, takes that everyday feeling and turns it into a way of thinking about what exchange rates should be over the long run.
The basic idea
Purchasing power parity starts from a simple principle. In a world without trade barriers or transport costs, the same basket of goods should cost the same everywhere once you convert the prices into a common currency. If it did not, people could buy goods where they are cheap and sell them where they are expensive, and that activity would push prices and exchange rates back into line.
From that principle comes the idea of a fair value for a currency. If a basket of goods costs £100 in the UK and $130 in the US, PPP would suggest an exchange rate of about 1.30 dollars to the pound. If the actual rate is very different, PPP suggests one currency is overvalued or undervalued in some sense.
Why inflation matters
A related version of the theory focuses on inflation. If prices rise faster in one country than another, its currency would be expected to lose value over time, so that the purchasing power of money stays roughly balanced across borders.
This is one reason traders pay attention to inflation differences between countries. Over long periods, a country with persistently higher inflation has often seen its currency weaken.
The famous burger test
The Economist magazine popularised PPP with its Big Mac Index, which compares the price of a single burger across countries. It started as a light-hearted idea, but it became a widely quoted rough guide to currency valuation precisely because it makes an abstract concept easy to grasp.
It also shows the limitations. A burger includes local wages, rent and taxes, none of which can be shipped across borders. That is part of why prices can stay different for a long time.
Why currencies drift away from PPP
In practice, exchange rates can sit far from PPP estimates for years. Several forces explain why.
Interest rates. Money tends to flow towards currencies offering higher returns. That can keep a currency strong even if it looks expensive on a PPP basis.
Capital flows. Investment in shares, bonds and businesses moves enormous sums across borders, and those flows often have nothing to do with the price of goods.
Risk and sentiment. In stressed times, investors often favour perceived havens, which can push those currencies away from any measure of fair value.
Non-traded goods. Haircuts, housing and many services cannot be traded internationally, so their prices do not need to equalise.
How traders use it
Because of those forces, PPP is not a timing tool. A currency that looks cheap can become cheaper, and one that looks expensive can stay expensive for a very long time. Traders who try to trade on PPP alone often find the market ignores them.
Where it can help is in setting long-term context. Take the euro, which has slipped to a 17-month low against the dollar amid worries about French public finances, while high US Treasury yields support the dollar. A PPP estimate can help frame whether that move is stretching the euro a long way from fundamental value, but it says little about when, or whether, the gap might close. Our guide to the EUR/USD pair explains the forces that drive that pair day to day.
PPP is also widely used by economists to compare living standards and the size of economies, because it adjusts for differences in local prices.
Keeping it in proportion
Think of PPP as a long-distance compass rather than a map for the next few days. It can tell you broadly where a currency might drift over many years, but short-term moves are dominated by interest rates, data and sentiment. Our explainer on reading the US dollar index is a useful companion for tracking the dollar’s broader moves.
If you would like a clearer idea of how well you understand the forces behind currency moves, our free trader assessment is a quick way to see where you stand and what to learn next.
