Home / Glossary / Purchasing Power Parity (PPP)
EconomicsPurchasing Power Parity (PPP)
By Sitraka Forler · Lecturer, Durham Business SchoolUpdated 13 September 2026 About this site
Exchange rates should equalise the price of identical goods.
In the long run, a basket costing $100 in the US and £80 in the UK implies a 1.25 USD/GBP rate. Deviations (like the Big Mac Index) flag over- or under-valued currencies. PPP is a long-run anchor, not a short-run trading signal.
One basket, two price tags: the PPP exchange rate
A fixed basket costs $120 in New York and £96 in London. The rate that equalises the tags is 120 / 96 = 1.25 $ per £.
PPP rate = $120 / £96 = 1.25 · £96 × 1.35 = $129.60 vs $120.00 in New York
The intuition
Purchasing power parity says an exchange rate is, at heart, the ratio of two price tags. Take one fixed basket of goods and price it in each country: if it costs $120 in New York and £96 in London, the only rate at which both tags agree is 120 divided by 96, or 1.25 dollars per pound. That is the PPP rate. In the chart above, the blue bar is the New York price and the gold bar is the London price converted at whatever market rate you choose; PPP is simply the rate that makes the two bars the same length.
The mechanism is arbitrage. Suppose the market rate sits at 1.35 while PPP says 1.25: converted into dollars, the London basket now costs 96 × 1.35 = $129.60, dearer than the $120 New York one. Anyone holding pounds does better buying in New York, so demand shifts toward cheap-country goods and away from the dear currency. Multiply that pressure across every tradable good and it slowly drags prices and the exchange rate back towards each other. Slide the gold marker away from the aqua one and the growing gap between the bars is exactly the profit that this trade is trying to eat.
That pull is real but glacial. Haircuts, rent and restaurant meals never cross borders, capital flows dwarf trade flows, and prices adjust slowly, so market rates wander a long way from parity and stay there for years. This is why The Economist's Big Mac Index reads as a joke with a serious core: one standardised basket, two price tags, one implied rate. In practice PPP is used as a long-run anchor and as the honest way to compare living standards across countries, not as a signal for next month's exchange rate.
Formula / theory
S = P_domestic / P_foreign
In Python
implied_fx = price_domestic / price_foreign misvaluation = market_fx / implied_fx - 1
Is sterling overvalued? Testing a $120 basket against a £96 one
- Price one identical basket in each city: $120.00 in New York and £96.00 in London.
- Implied PPP rate = P_US / P_UK = 120 / 96 = 1.25 dollars per pound.
- Take a market rate of 1.35 dollars per pound. In dollars the London basket costs 96 × 1.35 = $129.60.
- Compare the two dollar price tags: 129.60 / 120.00 = 1.08, so the London basket is 8.0% dearer.
- The same answer from the rates alone: 1.35 / 1.25 - 1 = 0.08, so sterling is 8.0% overvalued versus PPP.
- For the gap to close, either the market rate drifts down towards 1.25, or US prices inflate until the price ratio itself reaches 1.35: a New York basket at 96 × 1.35 = $129.60 would do it, since 129.60 / 96 = 1.35.
A currency's over- or undervaluation versus PPP is just the percentage gap between the market rate and the ratio of price levels, here 1.35 against 1.25, an 8.0% premium on sterling.
Common pitfalls
- Dividing the prices the wrong way round: quoted in dollars per pound, the PPP rate is P_US / P_UK = 120 / 96 = 1.25; flipping it gives 0.80, which is pounds per dollar, and reading that as dollars per pound turns an 8% overvaluation into a nonsense verdict.
- Trading on PPP at short horizons: deviations are large and persistent, with the empirical literature putting their half-life at roughly three to five years, so PPP says almost nothing about where a rate goes next quarter.
- Ignoring non-tradables: baskets are full of rent, haircuts and services that never cross borders, so richer countries systematically look overvalued (the Balassa-Samuelson effect); part of any measured gap is structural, not mispricing.
- Comparing GDP across countries at market exchange rates: this understates poorer economies where non-tradables are cheap; international comparisons by the IMF and World Bank use PPP rates for exactly this reason.
Frequently asked questions
What is purchasing power parity in simple terms?
Purchasing power parity (PPP) is the idea that exchange rates should equalise the price of the same basket of goods in two countries. If a basket costs $120 in the US and £96 in the UK, the PPP rate is 120 / 96 = 1.25 dollars per pound. When the market rate differs from this, one currency buys more real goods abroad than at home.
How is the PPP exchange rate calculated?
Divide the domestic price of a reference basket by the foreign price of the identical basket: S_PPP = P_domestic / P_foreign. With the domestic basket at $120 and the foreign one at £96, S_PPP = 120 / 96 = 1.25 dollars per pound. Comparing this with the market rate gives the over- or undervaluation: a market rate of 1.35 implies 1.35 / 1.25 - 1 = 8% sterling overvaluation.
Why do actual exchange rates deviate from PPP?
Because much of any price basket never crosses a border. Rent, haircuts and services cannot be arbitraged, productivity differences make them dearer in rich countries (the Balassa-Samuelson effect), and short-run rates are driven by capital flows and interest rates rather than goods trade. Add tariffs, transport costs and sticky prices, and deviations can persist for years even though the PPP anchor still tugs in the background.
Is PPP useful for forecasting exchange rates or trading?
As a long-run anchor, yes; as a short-run trading signal, no. Large PPP gaps do tend to close, but over horizons of several years, so the concept is mostly used to judge whether a currency looks cheap or dear and to compare GDP and living standards across countries, as the IMF and World Bank do. Short-run moves are dominated by interest rates, risk appetite and capital flows.
Test yourself
Further reading
Where to go deeper. Free means a full, legal copy is online.
An open-access survey of why real exchange rates depart from PPP, and how slowly they revert.