The law of one price: the seed of the whole idea
In the earlier guides of this rung you learned that the exchange rate is simply the price of one currency in another, set in the foreign-exchange market by everyone wanting to buy and sell. That left a natural question hanging: is there a *right* level the rate should sit at, or does it just float wherever the day's trading pushes it? Purchasing power parity is the oldest and simplest answer. It starts from one homely idea called the law of one price: the same good, sold in two places, should cost the same once you convert the prices into one currency.
Why should that be true? Because of arbitrage — the act of buying cheap in one place and selling dear in another for a riskless profit. Suppose gold trades for $2,000 an ounce in New York but, at today's exchange rate, the London price works out to $2,100. Traders would buy in New York, ship to London, and pocket $100 an ounce. That buying pushes the New York price up, the selling pushes the London price down, and the gap closes until the two prices meet. The law of one price is not a moral rule; it is just what relentless profit-seeking does to two prices for the identical thing.
From one good to a whole basket: PPP
Now scale the law of one price up from a single good to the whole shopping basket an ordinary household buys. If a basket that costs $100 in the United States costs £80 in Britain, then the exchange rate that makes them equal is $100 ÷ £80 = $1.25 per pound. That equalizing rate is purchasing power parity — the exchange rate at which a unit of money buys the same bundle of stuff in both countries. PPP is really just the law of one price wearing a coat made of many goods at once.
Basket of goods: US price = $100 UK price = £80
PPP exchange rate = US price / UK price
= $100 / £80
= $1.25 per £1
If the MARKET rate is $1.40 per £1:
the pound buys MORE dollars than its goods justify
=> the pound looks OVERVALUED against the dollar
=> the dollar looks UNDERVALUED (cheap to visit the US!)There are two flavours worth keeping straight. *Absolute* PPP is the strong claim above — that the market rate should equal the basket ratio right now. *Relative* PPP is gentler and far more believable: it says that over time, the currency of a high-inflation country should lose value against a low-inflation one at roughly the difference in their inflation rates. If American prices rise 2% a year and British prices rise 6%, relative PPP predicts the pound should depreciate by about 4% a year against the dollar, so that the faster-rising British prices don't price Britain out of world markets. Economists take relative PPP much more seriously than absolute PPP.
The Big Mac index: PPP you can eat
Measuring a whole basket is hard, so in 1986 *The Economist* magazine invented a wonderfully cheeky shortcut: use a single, near-identical good sold almost everywhere — a McDonald's Big Mac. The idea is that a Big Mac is a little basket of its own (beef, bread, lettuce, labour, rent, advertising), so its price across countries is a rough, edible test of PPP. Divide two countries' Big Mac prices and you get a 'burger PPP' rate to hold up against the actual market rate.
Here is how to read it. Say a Big Mac costs $5.00 in the US and the equivalent of $3.00 in Japan at the going market rate. The burger is cheaper in Japan, which means the same dollars buy more burger there — a signal that the yen looks undervalued against the dollar, roughly by the 40% gap. Travellers feel this directly: a country where everything seems astonishingly cheap to you is usually one whose currency sits below its PPP value. The index is deliberately playful and *The Economist* never claimed it was precise — but year after year it captures something real, and the burger has become a beloved teaching tool precisely because it makes an abstract theory you can taste.
Interest-rate parity: the other anchor
PPP anchors the exchange rate to the price of *goods*. But money also flows across borders chasing the price of *money* — interest rates. That gives a second anchor, interest-rate parity. The logic is once again arbitrage. If you can earn 1% a year by leaving money in dollars but 4% by parking it in pounds, the pound looks irresistible. So why isn't everyone piling in? Because investors must eventually convert back. Interest-rate parity says the extra 3% you earn in pounds should be exactly cancelled by an expected 3% depreciation of the pound over the year. The two routes — stay in dollars, or switch to pounds and switch back — must offer the same return, or arbitrage would erase the difference.
This is why a central bank raising interest rates often sees its currency strengthen at once: higher rates pull in foreign money, that demand bids up the currency, an appreciation you read about earlier in this rung. The flip side is sharp — if a country's rates fall or its promises lose credibility, money rushes out and the currency suffers a depreciation just as fast. Notice the tension: PPP says high-inflation currencies should *fall* to keep goods competitive, while higher interest rates (often used to fight that very inflation) can make a currency *rise* in the short run. Both forces are real; they simply act on different clocks.
Why reality drifts from PPP for years
Here is the honest part. As a prediction of where exchange rates sit today, PPP is, frankly, a poor forecaster — currencies can stray 20%, 30%, even 50% from their PPP value and stay there for a decade. The studies have a memorable name for this: the 'PPP puzzle.' So why does the theory survive? Because over *long* horizons — think years and decades, not days — rates do tend to crawl back toward PPP. It is a weak anchor with a long, slack chain, not a tight leash.
The reasons it drifts are not flaws to be embarrassed about — they are features of how the world actually works. First, many things people buy are non-tradable: a haircut, a doctor's visit, a restaurant meal, rent for an apartment. No arbitrageur can buy a cheap Bangkok haircut and resell it in Zurich, so those prices never get equalized. Rich countries tend to have expensive services (high wages bleed into everything local), which is why their overall price level — and the cost of that Big Mac, half of which is local labour and rent — runs systematically above poorer countries. This is a well-documented pattern, sometimes called the Balassa–Samuelson effect.
There are more reasons, and they stack up. Transport costs and tariffs keep prices apart. Taxes differ wildly — a Big Mac carries more tax in some countries than others. Brand and local market power let McDonald's charge what each market will bear, not one global price. And above all, currencies are traded vastly more for *finance* than for *goods*: trillions a day chase interest rates, safety, and speculation, swamping the slow tug of trade in burgers and shirts. So the market rate can wander far from PPP for as long as investors keep wanting to hold one currency over another. PPP tells you the gravitational centre; it does not tell you when the wandering planet will finally fall back toward it.