Purchasing Power Parity – PPP

An economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency’s purchasing power.

For example, consider a computer that costs 1,500 Euros in Germany and an exchange rate of 2 Euros to 1 U.S. Dollar. If the same computer cost 1,000 dollars in the United States, U.S. consumers would buy the computer in Germany. If done on a large scale, the influx of U.S. dollars would drive up the price of the Euro, until it equalized at 1.5 Euros to 1 U.S. Dollar – the same ratio of the price of the computer in Germany to the price of the computer in the U.S.

The theory only applies to tradable goods, not to immobile goods or local services. The theory also discounts several real world factors, such as transportation costs, tariffs and transaction costs. It also assumes there are competitive markets for the goods and services in both countries.

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