Exchange Rate vs Purchasing Power Parity (PPP)
Exchange Rate and Purchasing Power Parity (PPP) are related concepts in AP Economics that students often mix up. In short: exchange rate is an exchange rate is the price of one country's currency expressed in terms of another currency. Meanwhile, purchasing power parity (ppp) is purchasing power parity is the idea that exchange rates should adjust so a basket of goods costs the same across countries. Here is how they compare side by side.
An exchange rate is the price of one country's currency expressed in terms of another currency.
It is set in the foreign exchange market by the supply of and demand for currencies. A higher exchange rate (appreciation) makes imports cheaper and exports more expensive. Exchange rates affect net exports and aggregate demand.
Purchasing power parity is the idea that exchange rates should adjust so a basket of goods costs the same across countries.
PPP is used to compare living standards and real GDP across nations more fairly than market exchange rates, which can be distorted. The 'Big Mac Index' is a popular informal PPP measure.
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