What is purchasing power parity?

Purchasing power parity (PPP) is an economic theory stating that exchange rates should adjust so that identical goods cost the same in different countries when expressed in a common currency. If a basket of goods costs $100 in the United States and 90 euros in Germany, the PPP exchange rate is $1.11 per euro. If the actual market exchange rate deviates from PPP, the theory predicts a gradual convergence over time as trade arbitrage and capital flows respond to price differences.

The most famous popular application of PPP is The Economist's Big Mac Index, which compares the price of a McDonald's Big Mac across countries to estimate currency misalignment. If a Big Mac costs $5.50 in the US and the equivalent of $3.80 in Japan at current exchange rates, the yen would be considered approximately 30% undervalued relative to Big Mac PPP. While simplistic, the Big Mac Index captures the intuition behind PPP in a relatable way.

In practice, exchange rates deviate from PPP for extended periods, sometimes decades. Structural factors that cause persistent deviations include the Balassa-Samuelson effect (higher-productivity countries have higher price levels because their non-tradable goods are more expensive), capital flow patterns (reserve currency demand supports the dollar above PPP), trade barriers (tariffs and transport costs prevent full arbitrage), and different consumption baskets across countries.

For currency analysis, PPP serves as a long-run anchor rather than a short-term predictor. When a currency trades far above its PPP-implied value, it is considered overvalued, and the odds of eventual depreciation increase, though the timing is highly uncertain. The dollar has traded above PPP against most major currencies for much of the past decade, reflecting reserve currency demand, higher US real yields, and relatively stronger US growth. PPP-based models suggest that over 10-20 year horizons, currencies do tend to converge toward PPP, making it useful for long-term strategic asset allocation decisions even if it offers little short-term trading value.