Purchasing Power Parity

Published Jan 14, 2023

Definition of Purchasing Power Parity

Purchasing Power Parity (PPP) is an economic theory that states that the exchange rate between two currencies is equal to the ratio of the two countries’ price levels. That means it is a measure of the relative purchasing power of two currencies in different economies. Or in other words, it is a way to compare the cost of living in different countries.

Example

To illustrate this, let’s look at the exchange rate between the US dollar and the Japanese yen. According to the PPP theory, the exchange rate should be equal to the ratio of the two countries’ price levels. So let’s say the the price of an apple in Japan is JPY 260.00 and USD 2.00 in the United States. In that case, the exchange rate between the two countries can be calculated as 260/2, which equals 130. Or in other words, one U.S. dollar is worth 130 Japanese yen, according to PPP.

Why Purchasing Power Parity Matters

Purchasing Power Parity is an important concept in international economics. It is used to compare the cost of living in different countries and to measure the relative purchasing power of different currencies. It is also used to calculate the real exchange rate, which is the exchange rate adjusted for differences in price levels. This is important for international trade, as it allows companies to compare the cost of goods and services in different countries.