The theory of purchasing power parity (PPP) states that the ratio of price levels between two countries is equal to their exchange rate. Price levels are determined by a basket of goods and services freely available in both countries and that don’t suffer distortions due to transportation costs or excise taxes. Inflation, the general increase in prices, is inversely related to exchange rates: as one goes up, the other must go down to maintain equilibrium.
Law of One Price
The “law of one price” states that arbitrage will force prices between two countries to equalize around a basket of goods and services, discounting transaction costs. For instance, if you can exchange one U.S. dollar for one and a half Canadian dollars (C$), then a TV priced at $500 in the U.S. should cost C$750 in Canada. If it cost only C$700, Americans would purchase their TV’s in Canada. To do so, Americans would have to sell U.S. dollars and buy Canadian dollars, the effect of which would be to weaken the U.S. dollar and strengthen the Canadian dollar. Eventually, the strong Canadian dollar would force the Canadian price of the TV to rise to C$750, re-establishing equilibrium.
The Canadian TV example describes absolute PPP, the equalization of price levels among different countries. Mathematically, this is expressed by the following:
The price level in country one divided by the price level in country two equals the exchange rate between the two countries.
Thus, the Canadian price level divided by the American price level gives the Canadian-to-American exchange rate. Any violation of this equation puts pressure on exchange rates until the equation reaches equilibrium.
This variant of PPP deals with the rate of change of price levels, also known as the inflation rate. Currency will appreciate or depreciate according to the difference in the inflation rates between two countries. If Canada’s annual inflation is 1 percent and the American inflation rate is 3 percent, the U.S. dollar should depreciate 2 percent a year.
Actual Impact on Exchange Rates
PPP does not affect exchange rates in the short term. Rather, economic and political news, such as changes in the money supply or interest rates, drive short-term exchange rates. PPP does have a long-term impact on exchange rates because long-term economic trends help determine inflation, and therefore change exchange rates. The University of British Columbia posits that, “a time horizon of four to 10 years would be typical.”
Big Mac Index
"The Economist" magazine has a yearly survey of worldwide prices for a McDonald’s Big Mac hamburger. A $4 American price vs. a 3 euro French price implies an exchange rate of $1.33 per euro. Although somewhat whimsical, the core question is pertinent: how do different countries price their goods? Of course, a more scientific approach requires a basket of goods and services, although local cultural differences may make it difficult to compare PPP among different countries.