The Basics
- Simple definition: An economic theory that exchange rates should adjust to equalize the price of identical goods and services in different countries.
- Core idea: A basket of goods should cost the same in all countries when measured in a common currency.
- Think of it as: The law of one price applied across borders, meaning no arbitrage opportunities exist in the long run.
What It Actually Means
PPP has two versions. Absolute PPP holds that the exchange rate equals the ratio of price levels. Relative PPP holds that exchange rate changes offset inflation differentials. If Pakistan inflation is 10 percent and US inflation is 2 percent, the rupee should depreciate by about 8 percent to maintain PPP. In reality, PPP holds poorly in the short run due to trade barriers, non-tradable goods, transport costs, and market power. However, it guides long-run exchange rate expectations and is used for cross-country income comparisons through PPP-adjusted GDP.
Example
A Big Mac costs Rs. 1,000 in Pakistan and $5 in the United States. Absolute PPP implies the exchange rate should be 200 rupees per dollar. If the actual rate is 280, the rupee is undervalued by about 30 percent, meaning Pakistani goods are cheap to Americans.
Why It Matters (2026)
PPP helps compare living standards across countries using PPP-adjusted GDP per capita. It signals whether currencies are overvalued or undervalued. For Pakistan, PPP estimates often suggest the rupee is undervalued, indicating potential for adjustment.
See also
Real Exchange Rate • Law of One Price • Inflation Differential • Big Mac Index • Overvaluation
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