Purchasing Power Parity (PPP) is a principle in international finance that states that the exchange rate between two currencies should equal the ratio of the domestic price level to the foreign price level. In other words, PPP states that a basket of goods should cost the same in both countries after accounting for exchange rate changes. This principle helps explain differences in the cost of living between countries and is commonly used to convert economic data between currencies.
There are three types of PPP:
- Absolute PPP: States that the exchange rate between two currencies should equal the ratio of the domestic price level to the foreign price level. In other words, the same basket of goods should cost the same in both countries after accounting for exchange rate changes.
- Relative PPP: States that the rate of change in the exchange rate between two currencies should equal the rate of change in the ratio of the domestic price level to the foreign price level. In other words, the relative price of goods should remain constant over time, even if absolute prices change.
- Ex-ante Relative PPP: States that the expected future rate of change in the exchange rate between two currencies should equal the expected rate of change in the ratio of the domestic price level to the foreign price level. In other words, the expected relative price of goods should remain constant over time, even if expected absolute prices change.
PPP is a theoretical construct and assumes that goods are freely traded between countries, that there are no transaction costs or taxes, and that markets are efficient. In reality, deviations from PPP may occur due to trade barriers, transportation costs, taxes, and other market imperfections.Regenerate response
See also: International parity conditions, Covered interest rate parity, Uncovered interest rate parity, Forward rate parity, International Fisher effect
