The purchasing power parity model is based on the theory that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. An increase in a country's domestic price level means a change in its inflation rate. When this happens, the inflation rate is expected to be offset by an equivalent but opposite change in the exchange rate. According to the purchasing power parity model, if the value of a hamburger, for instance, is 2USD in the US and 1GBP in the UK, then the GBP/USD exchange rate must be 2USD per 1GBP (GBP/USD 2.0000).

What if the actual interbank exchange rate displays GBP/USD 1.5000? In this case the Pound Sterling would be considered undervalued and the US Dollar overvalued.

Therefore, according to this model the two currencies should move towards the 2:1 ratio which is the price difference that same goods in both countries have. This also means that when a country's inflation is rising, the exchange rate for its currency should depreciate in relation to other currencies, in order to return to parity.

Facts Box - When reading about the purchasing power parity, you'll notice many authors compare prices of hamburgers. There is a reason why hamburgers are a popular example: the weekly news and international affairs publication “The Economist” publishes the Big Mac Index which is an informal way to measure the purchasing power of two countries comparing the price of a Big Mac hamburger sold by McDonald's.

A more formal measurement is published by the Organization for Economic Cooperation and Development (OCDE) using a basket of consumer goods and provides information as to whether the different currencies are under- or over valued against the USD.

You can use the below links to compare both indicators:

Big Mac Index [link to [You must be registered and logged in to see this link.]

OECD PPP Index (click on “OECD statistics on Purchasing Power Parities (PPP)”) [link to [You must be registered and logged in to see this link.] [end of Facts Box]

In the absence of transportation and other transaction costs such as tariffs or taxes, competitive markets should theoretically equalize the price of an identical good in two countries (with prices expressed in the same currency). But in reality such costs exist and influence the cost of goods and services, and therefore should be considered when weighing prices. Unfortunately the purchasing power parity model does not reflect those costs when determining the exchange rates, being this its major weakness. Another weakness is the fact that the model only applies for goods and ignores services. Furthermore, other factors such as inflation and interest rate differentials impacting exchange rates, are not taken into account in this model.

FAQ Box - Does the purchasing power parity model serves to determine exchange rates in the short-term? No. This model is a measure to anticipate the long run behavior of exchange rates but not to trigger trades in the short-term. The idea behind this model is that economic forces will eventually equalize the purchasing power of currencies in different countries, a phenomenon which typically takes several years as the empirical evidence of the model shows.