Purchasing power parity
Purchasing power parity is the idea that exchange rates should adjust so that a basket of goods costs the same across countries.
If a basket of goods costs far more in one country than another once you convert the currencies, something has to give. Purchasing power parity is the theory of how, eventually, it does.
Purchasing power parity is the idea that, in the long run, exchange rates should adjust so that a given basket of goods costs the same across countries when expressed in a common currency. It rests on the logic that, absent barriers, prices for the same goods should not differ persistently between places.
The law of one price, writ large
The intuition is the law of one price applied to whole baskets: if a good is much cheaper in one country, people will buy it there and sell it elsewhere, and this arbitrage, along with shifts in trade, should push exchange rates toward equality of purchasing power. The lighthearted Big Mac index, comparing the price of a burger across countries, is a popular illustration of whether currencies look cheap or dear relative to this benchmark.
Why it holds only loosely
In practice, purchasing power parity holds poorly in the short run and only roughly in the long run. Many goods and most services cannot be traded across borders, transport costs and trade barriers intervene, and exchange rates are driven by capital flows and sentiment that swamp goods-price arbitrage for long periods. So actual exchange rates can deviate from parity for years, which is why the theory is a long-run anchor rather than a short-run predictor.
What it is good for
Despite its weak short-run record, purchasing power parity is useful in two ways. It provides a benchmark for judging whether a currency is overvalued or undervalued relative to fundamentals. And it is essential for comparing living standards across countries, since converting incomes at market exchange rates can badly mislead when prices differ; comparisons adjusted for purchasing power give a truer picture of what incomes actually buy.
Purchasing power parity is a theory that is more valuable as a conceptual anchor than as a forecasting tool. It captures a real long-run force, that price differences create pressures toward equalisation, while its frequent violation in practice is itself instructive about how far real exchange rates are driven by finance rather than by the prices of goods.