Purchasing Power Parity

Purchasing power parity rests on a hierarchy of increasingly demanding claims. The law of one price is the narrowest: a single identical good, freely tradable and free of transport costs or barriers, should sell for the same money-equivalent price everywhere once converted at the spot rate. Absolute PPP extends that claim from one good to a broad, identically weighted basket, implying that the nominal exchange rate equals the ratio of national price levels. Relative PPP abandons the level statement and speaks only to changes: even if a currency starts out mispriced, the percentage move in the spot rate should offset the gap in inflation between the two economies, leaving relative purchasing power unchanged.

The forward-looking version, sometimes called ex ante PPP, applies the same logic to expectations: currencies of countries with higher expected inflation should be expected to depreciate by the differential. This is the form that connects PPP to the wider set of international parity conditions.

Fix the quote convention first, because the sign of the answer depends on it. With a rate quoted as units of price currency per one unit of base currency, relative PPP says the expected percentage change in that rate equals one plus the price-currency country's inflation rate divided by one plus the base-currency country's inflation rate, minus one. The common approximation simply subtracts base-currency inflation from price-currency inflation. A positive result means more price currency per unit of base currency, that is, depreciation of the price currency and appreciation of the base currency.

So the higher-inflation currency is the one expected to weaken. Candidates who lose marks here almost always do so by attaching the differential to the wrong side of the quote rather than by mishandling the arithmetic, so it is worth restating the answer as a sentence naming which currency appreciates.

Empirically, PPP is a poor guide over months and quarters and a considerably better one over horizons measured in decades. Several frictions explain the gap. Baskets include services, housing and other non-tradables that no arbitrage mechanism disciplines across borders. Transport costs, tariffs, quotas, taxes and differing distribution margins drive wedges even in tradable goods. Consumption weights differ across countries, so the baskets being compared are not truly identical.

The Balassa-Samuelson effect adds a systematic bias rather than noise: productivity growth concentrates in the tradable sector, but wage gains spread economy-wide, pushing up non-tradable prices in richer, faster-growing economies. Their currencies therefore look persistently overvalued on a PPP basis, and their real exchange rates trend upward. That persistence is why PPP deviations are best read as slow-moving signals, not trading triggers.

PPP underpins the real exchange rate, which adjusts the nominal rate for relative price levels. If relative PPP held exactly, the real rate would be constant; observed movements in real rates are precisely the measure of PPP deviation, and a currency appreciating in real terms is losing competitiveness in tradable goods. The same logic drives cross-country income comparisons: converting GDP at market rates understates output in economies where non-tradables are cheap, so multilateral institutions publish GDP at PPP conversion factors for comparisons of living standards.

At Level I, be able to compute an expected spot rate from an inflation differential, state which currency appreciates, translate a PPP deviation into an overvalued or undervalued judgement, and place PPP alongside covered and uncovered interest rate parity, the international Fisher effect and the Fisher relation within the single parity framework.