purchasing power parity

Here is a puzzle. The same identical thing — a Big Mac, a litre of milk, a haircut — costs wildly different amounts of money in different countries once you convert at the market exchange rate. A meal that feels expensive in Switzerland feels cheap in India even after exchanging your money. Purchasing power parity is the idea that, in the long run, exchange rates should move so that a given amount of money buys roughly the same basket of goods everywhere. Its simplest form, the law of one price, says one identical good should cost the same in two countries once you account for the exchange rate.

The logic is arbitrage: if a widget cost 1 dollar in America and the equivalent of 2 dollars in Britain, traders could buy cheap in America and sell dear in Britain, and that buying and selling would push the prices (and the exchange rate) until the gap closed. The famous, light-hearted test is The Economist's Big Mac index, which compares the price of a Big Mac across countries. If a Big Mac costs 5 dollars in the US and the equivalent of 3 dollars in Mexico, PPP suggests the peso is 'undervalued' against the dollar — your dollars buy more burger there than at home. PPP also gives economists a fairer way to compare living standards: converting incomes at PPP rather than market rates corrects for the fact that the same salary stretches much further in cheaper countries.

PPP is a powerful idea but a rough one, and honesty demands the caveats. It works far better for the long run than the short, because exchange rates can stray from PPP for years. It works for tradable goods you can ship and arbitrage, but not for haircuts, rent or restaurant meals, which cannot be moved across borders and stay cheap where wages are low. Real baskets differ between countries, and taxes, tariffs and transport costs all drive a wedge. So PPP is best treated as a gravitational pull that exchange rates tend toward over time, not a precise prediction of where a currency will trade tomorrow.