Purchasing power parity

The theory that, in the long run, exchange rates should adjust so that the same basket of goods costs the same price everywhere.

In brief

Formalised by the Swedish economist Gustav Cassel from 1918 onwards, in the debate on the return to the gold standard after the First World War.
Central idea: the equilibrium exchange rate between two currencies is the ratio of their domestic purchasing powers.
Absolute PPP compares the price of an identical basket; relative PPP compares price changes.
Recognised limitations: non-tradable goods and services (rents, local labour), taxation, transport costs, margins — which cause prices to diverge durably.
Used to convert GDP into “PPP dollars” (World Bank, IMF, OECD) in order to compare living standards.

The principle is intuitive: if the same good costs twice as much in country A as in country B once prices are converted, something should eventually correct the gap — either prices or the exchange rate.

In practice, the theory holds only very imperfectly, and over long periods. The main reason lies in non-tradable goods: the rent on premises, a crew member's wage, the price of land cannot be arbitraged from one country to another. Yet these costs go into the price of a hamburger — which explains part of the gaps measured by the Big Mac Index and makes the indicator systematically unfavourable to low-wage countries.

Sources

External sources.

Purchasing Power Parity: Weights Matter — International Monetary Fund

Sources

Where this comes up in the case file

Other glossary entries — Economics