How to Calculate Purchasing Power Parity
The PPP exchange rate equals the price of a basket in one currency divided by the price of the same basket in the other currency.
The Purchasing Power Parity formula
Calculator
Price one basket in each currency to get the PPP exchange rate, then compare it with the market rate.
What the fixed basket costs at home, in dollars in this example.
The identical basket abroad, priced in the other currency.
Units of currency A per 1 unit of currency B, as traded today.
Equalizing the basket takes $1.25 of currency A per 1 unit of currency B.
- PPP rate, quoted the other way
- 0.8
- Gap between the market rate and PPP
- 20%
- Reading
- Currency B overvalued
The same rate reads as 0.8 units of currency B per 1 unit of currency A.
The market rate of $1.5 sits 20% above the PPP rate of $1.25.
A market rate above the PPP rate means the currency in the denominator costs more than its purchasing power justifies.
How to calculate Purchasing Power Parity, step by step
- 1Price one identical basket in both countries. Use the same goods in the same quantities, priced in each country's own currency.
- 2Divide one price by the other. PPP rate = price in currency A ÷ price in currency B, which gives units of A per one unit of B.
- 3Compare it with the market rate. If the market rate sits above the PPP rate, the currency in the denominator is overvalued; below it, undervalued.
- 4Size the gap. Percentage overvaluation or undervaluation = (market rate − PPP rate) ÷ PPP rate × 100.
Worked example: Purchasing Power Parity
A fixed basket of goods costs $150 in the United States and 120 pounds in the United Kingdom. The PPP exchange rate = 150 ÷ 120 = $1.25 per pound, which is the same rate as 120 ÷ 150 = 0.80 pounds per dollar. If the market rate is $1.50 per pound, the pound trades above the rate that would equalize purchasing power by (1.50 − 1.25) ÷ 1.25 × 100 = 20%, so the pound is overvalued and the dollar is undervalued against it.
Purchasing Power Parity questions
What is the difference between absolute and relative PPP?
Absolute PPP sets the exchange rate equal to the ratio of basket prices today, while relative PPP says the exchange rate changes over time by roughly the gap between the two countries' inflation rates.
Why do actual exchange rates differ from PPP?
Transport costs, tariffs, taxes, and non-traded items like rent and haircuts stop prices from equalizing. Short-run rates are also driven by financial flows rather than goods prices.
What is the Big Mac index?
It is a simple PPP test that treats one burger as the basket: divide the two local prices to get an implied rate, then compare that with the market rate to see which currency looks cheap.
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