Definition
Purchasing Power Parity (PPP)
Purchasing power parity holds that exchange rates should equalise the price of an identical basket of goods across countries, so a currency's true value reflects what it can buy.
Under PPP, if a basket costs USD 100 in America and ₹4,000 in India, the implied exchange rate is 40 rupees per dollar, even if the market rate is 83. The gap shows the rupee is 'cheaper' in PPP terms, typical for developing economies.
PPP is why India's economy ranks far higher by PPP-adjusted GDP than by market exchange rates: the rupee buys more locally than the nominal rate suggests. The Big Mac index is a playful, real-world test of PPP.
Related terms
- Uncovered Interest Rate ParityUncovered interest rate parity theorises that a higher-yielding currency should depreciate over time by exactly the interest-rate gap, leaving no excess return from a carry trade once exchange-rate moves are accounted for.
- Real Effective Exchange Rate (REER)REER is a trade-weighted index of a currency against a basket of partner currencies, adjusted for inflation differences, measuring true competitiveness rather than a single bilateral rate.
- Big Mac IndexThe Big Mac index is The Economist's light-hearted gauge of currency valuation, comparing the price of a McDonald's Big Mac across countries to test purchasing power parity.
- Comparative AdvantageComparative advantage is the principle that countries gain by specialising in goods they produce at the lowest opportunity cost and trading for the rest, even if one is better at everything.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.