Purchasing Power Parity

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neighbor’s currency to be in great demand, thereby driving its price up.
What in fact sets the exchange ratio between two currencies? Obviously supply and demand, but what causes supply and demand to set exchange rates at appropriate levels? With this question we begin the next section.

What is Purchasing Power Parity?

Perhaps the single most well known concept in foreign exchange theory is that of Purchasing Power Parity (PPP). The basic idea of PPP is that currencies represent purchasing power over goods and services. Either the exchange rate or price levels adjust to keep purchasing power constant. For example, say a particular basket of goods sells for $2000 in America and 1000 GBP in Great Britain. According to PPP, the exchange rate of dollars to pounds should be 2:1. If it were not 2:1; if, for example only 1.5 dollars was needed to purchase 1 pound, an arbitrageur would buy the basket of goods for 1000 pounds ($1500) and resell them in America for ...

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Obviously, in a situation involving substantial transaction costs relative to the cost of the commodity in question, LOP will be empirically meaningless. Second, for this formulation to hold true, there must no barriers to trade. This would include prohibitions, tariffs, taxes, and quotas. Lastly, and perhaps most obviously, is that we must be comparing homogeneous goods.

The absolute version of PPP hypothesizes a similar relationship, with the exception that it uses price levels instead of specific commodity prices. Mathematically, the absolute version of PPP can be expressed thus:
P(t) = S(t) x P*(t), where
P(t) = the domestic price level in domestic currency
P*(t) ...

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