How does Purchasing Power Parity (PPP) explain exchange rate movements, and does it actually work?

Purchasing Power Parity is one of the most important (and most debated) exchange rate theories. It works well as a long-run anchor but poorly for short-term predictions.

Absolute PPP

A basket of goods should cost the same in every country when converted to a common currency:

S(A/B) = Price Level in Country A / Price Level in Country B

If a basket costs $100 in the US and EUR80 in Germany:

S(USD/EUR) = 100/80 = 1.25 USD per EUR

Relative PPP

More practically useful. It says the exchange rate should change by the inflation differential:

% Change in S(A/B) = Inflation_A - Inflation_B

Example — Marston Analytics Currency Forecast

Marston's economist forecasts for the next year:

• US inflation: 3.5%
• UK inflation: 2.0%
• Current spot rate: 1.28 USD/GBP

Relative PPP prediction:

% Change in USD/GBP = 3.5% - 2.0% = +1.5%

Expected future rate = 1.28 x (1.015) = 1.299 USD/GBP

The USD is expected to depreciate by 1.5% against the GBP because the US has higher inflation — US goods are becoming relatively more expensive, so the dollar weakens.

Does PPP Work in Practice?

Why PPP Fails in the Short Run:

1. Capital flows — Investment flows (not trade flows) dominate currency markets. A country with high interest rates attracts capital, strengthening its currency regardless of inflation.

1. Non-traded goods — Haircuts, rent, and local services can't be arbitraged across borders. They comprise 50%+ of most price indices.

1. Trade barriers — Tariffs, transportation costs, and regulations prevent goods prices from equalizing.

1. Sticky prices — Companies don't change prices instantly when exchange rates move.

1. Balassa-Samuelson effect — Productivity differences between traded and non-traded sectors cause real exchange rate deviations in developing countries.

The Big Mac Index (Informal PPP Test):

The Economist's Big Mac Index compares burger prices globally. If a Big Mac costs $5.50 in the US and CHF 6.50 in Switzerland, the implied PPP rate is 6.50/5.50 = 1.18 CHF/USD. If the actual rate is 0.88 CHF/USD, the Swiss franc is 'overvalued' by about 34% relative to PPP.

Exam Tip: CFA Level I often asks you to calculate the expected exchange rate under relative PPP given two inflation rates. Remember: the higher-inflation currency depreciates. Be careful with the currency quotation convention (which currency is in the numerator).

Study exchange rate models in our CFA Level I Economics course.