PPP- (Purchasing Power Parity) Exchange Rates

Question 1

What is Purchasing Power Parity (PPP)?

Answer 1

PPP is the theory that exchange rates should adjust to ensure that the same basket of goods costs the same amount in different countries when expressed in a common currency.

Question 2

What does PPP suggest about over- or under-valued currencies?

Answer 2

If a currency buys more than it should → overvalued

If a currency buys less than it should → undervalued

This can indicate potential exchange rate correction over time.

Question 3

What is the formula for PPP exchange rate?

Answer 3

PPPExchangeRate=
CostofBasketinForeignCurrency
CostofBasketinDomesticCurrency
​

Question 4

How is the real exchange rate different from nominal?

Answer 4

RealER

Nominal exchange rate: market rate (e.g. £1 = $1.70)

Real exchange rate adjusts for price levels/inflation

NominalER
×
𝑃
UK
𝑃
US
RealER=
P
US
​

NominalER×P
UK
​

​

If the real ER ≠ 1, then PPP does not hold.

Question 5

Big Mac Index Example

Answer 5

Country Big Mac Price (USD) Implied PPP (vs $4.74 in US) Over-/Undervalued
Switzerland$7.54 $7.54 / $4.74 = 1.59 Overvalued
China $2.44 $2.44 / $4.74 = 0.51 Undervalued

Question 6

What are the limitations of PPP theory?

Answer 6

Not all goods are tradable (e.g. haircuts, housing)

Transport costs and tariffs distort prices

Quality differences between products

Takes time for price and wage adjustments