Purchasing Power Parity (PPP) for Exchange Rates

Readers Question: how could the purchasing power parity help in determining  the new exchange rates after a war. (post war realignment)

Purchasing Power Parity PPP is a theory which suggests that exchange rates are in equilibrium when they have the same purchasing power in different countries.

A very simple example.

Suppose a Big Mac costs £2 in the UK and $4 in the US. The correct exchange rate according to purchasing power parity would by £1 in $2. This would leave a customer indifferent to buying the good in the UK and buying it in the US.

Suppose an Apple Mac costs £1,000 in the UK and $1000 in the US. An exchange rate of £1 to $2 suggests that it is much cheaper to buy the Mac in America. Therefore, UK citizens will want to import the good from America, this will involve selling pounds and buying dollars causing the Pound to depreciate.

Purchasing Power parity will involve looking at a basket of goods to determine effective living costs.

Of course, exchange rates often diverge from purchasing power parity for long periods of time. This reflects other factors such as the risk and stability of investing in a certain country. It also depends on interest rates which attract hot money flows.

According to purchasing power parity which countries are overvalued?

The Euro and Yen look overvalued on purchasing power.

The Pound was overvalued in the dollar when it was at $2 to £1. This overvaluation was one reason why the Pound devalued recently.

Understanding exchange Rates

Factors influencing exchange rates