What Is Purchasing Power Parity (PPP)? How It Is Calculated

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Purchasing power parity (PPP) is the exchange rate at which two currencies would buy the same basket of goods and services in their own countries. If a basket costs $100 in the United States and 1,500 units of another currency abroad, the PPP rate is 1,500 per dollar, whatever the foreign exchange market quotes. Economists use PPP to compare price levels, living standards and economic output across countries with different currencies. It is also a long-standing theory of exchange rates: over long periods, currencies should drift toward the rate that equalizes prices.

How purchasing power parity works

PPP rests on the law of one price: in a competitive market with no trade barriers or transport costs, an identical good should cost the same everywhere once prices are converted into a common currency. If it did not, traders could buy where the good is cheap and sell where it is dear until the gap closed. PPP extends that idea from a single product to a broad basket of goods and services.

The PPP formula

The absolute version of PPP is calculated as:

S = P1 / P2

where:

• S = the PPP exchange rate (units of currency 1 per unit of currency 2)
• P1 = the cost of the basket in currency 1
• P2 = the cost of the same basket in currency 2

Relative PPP

The relative version deals with changes over time rather than price levels. It holds that the exchange rate should move by roughly the difference between the two countries’ inflation rates. A currency whose country runs higher inflation should depreciate against a currency with lower inflation, because each unit buys less at home. Inflation for this purpose is typically measured with a price index such as the Consumer Price Index.

In formula form: expected exchange rate = current rate × (1 + foreign inflation) / (1 + domestic inflation).

Worked example (hypothetical)

Assume a basket of goods costs $200 in the United States and 3,000 pesos in a hypothetical Country B.

1. PPP rate: 3,000 / 200 = 15 pesos per dollar.
2. Compare with the market: suppose the market exchange rate is 20 pesos per dollar. At that rate, the Country B basket costs 3,000 / 20 = $150, or $50 less than in the U.S.
3. Price level ratio: 15 / 20 = 0.75. Prices in Country B are 75% of U.S. prices once converted at the market rate. By the PPP measure, the peso is undervalued by about 25% against the dollar.

Now apply relative PPP. Assume U.S. inflation of 3% and Country B inflation of 8% over the next year, with the market rate starting at 20. The rate implied by relative PPP is 20 × 1.08 / 1.03, or about 20.97 pesos per dollar, a peso depreciation of just under 5%.

Interpreting the result

A currency whose market rate makes its basket cheaper than the PPP rate would is said to be undervalued; one whose market rate makes it more expensive is overvalued. These labels describe a gap against a theoretical benchmark, not when or whether the market rate will close it.

How PPP is used

PPP-adjusted GDP

To compare gross domestic product across countries, nominal GDP, measured at current prices, must be converted into a common currency, and the choice of conversion rate matters.

Take Country B again, with a hypothetical nominal GDP of 6 trillion pesos:

• At the market rate of 20, GDP is $300 billion.
• At the PPP rate of 15, GDP is 400 billion international dollars.

The international dollar is a hypothetical unit with the same purchasing power a U.S. dollar has in the United States. The higher PPP figure reflects that a peso goes further inside Country B than the market rate suggests. Dividing PPP GDP by population gives GDP per capita at PPP, the standard measure for comparing average living standards.

Neither figure is “better” for a country to have. Nominal GDP shows what an economy’s output is worth in international markets, which matters for paying for imports, servicing foreign-currency debt or measuring weight in global trade. PPP GDP shows how much output residents can actually consume at local prices. For lower-income countries, where many local goods and services are cheap, PPP figures are usually well above nominal ones, so rankings of economic size can differ noticeably between the two measures.

Who produces and uses PPP data

The University of Pennsylvania and the United Nations established the International Comparison Program (ICP) in 1968 to price comparable goods and services across many countries. Its worldwide price survey produces the PPPs that underpin comparisons published by the World Bank, the International Monetary Fund and the OECD, and researchers use them to estimate global productivity, growth and poverty.

Outside official statistics, some forex traders use PPP to flag currencies that look overvalued or undervalued, and investors holding foreign stocks or bonds may use PPP figures to judge how exchange-rate moves could affect an economy and their holdings.

The Big Mac Index

Since 1986, The Economist has tracked the price of a McDonald’s Big Mac across many countries. Because the burger is close to identical everywhere, its price works as a one-item basket: dividing the local price by the U.S. price gives an implied PPP rate to set against the market rate. A 2003 Federal Reserve Bank of St. Louis paper, “Burgernomics,” by Michael R. Pakko and Patricia S. Pollard, used it to examine why prices do not equalize in practice.

Limitations of purchasing power parity

PPP assumes conditions that real markets rarely meet. The main sources of deviation:

• Transport costs. Goods not produced locally must be imported, and freight and import duties raise their price relative to locally sourced equivalents.
• Tax differences. Sales taxes and value-added taxes (VAT) vary by country and push consumer prices up in some markets relative to others.
• Government intervention. Tariffs and quotas can make imported goods far more expensive in one country than the same products elsewhere.
• Non-traded inputs and services. Rent, labor, utilities and insurance make up much of a product’s price and cannot be shipped across borders, so they need not reach parity.
• Market competition. A firm with a competitive advantage, a monopoly or a cartel can keep prices high in a particular country.
• Basket design. Countries consume different things, and quality varies. A basket weighted toward one country’s spending habits can misstate prices in another, and the choice of weights changes the result.

Because of these frictions, PPP works better as a long-run anchor than as a guide to short-term exchange-rate moves, which are also driven by interest rates, capital flows and expectations.

PPP vs. related concepts

PPP rate vs. market exchange rate. The market rate is what you actually pay to swap currencies today, set by supply and demand for the currencies. The PPP rate is a calculated benchmark based on goods prices. You cannot trade at the PPP rate.

PPP vs. cost of living. A cost-of-living comparison measures how expensive a specific place, often a city, is for a particular kind of household, and usually covers housing and local services in detail. PPP is a national conversion rate built from a broad basket for comparing whole economies, so it will not tell you whether a salary in one city stretches as far as in another.

PPP vs. interest rate parity. Interest rate parity links exchange rates to interest rate differences: the forward exchange rate should offset any interest advantage of holding one currency over another. PPP links exchange rates to price levels and inflation. Both are parity conditions, but they explain different things.

FAQs

The Bottom Line

PPP matters most to economists comparing living standards and output across countries, and to traders and investors gauging whether a currency looks overvalued or undervalued. Treat it as a long-run anchor rather than a short-term forecast, since interest rates, capital flows and expectations also move exchange rates. A gap from PPP says nothing about when or whether the market rate will close it.