Purchasing Power Parity

Suppose the same drink costs very different prices at the convenience store across the street and the one in your neighborhood. People would all crowd into the cheaper one. In the end, the two stores' prices would end up close. The principle that the same freely traded item should cost the same everywhere is called the law of one price.

Purchasing power parity stretches this simple principle across countries. What if a hamburger that costs 6,500 won in Korea sells for exactly $5 in the United States? For the two burgers to be worth the same, 6,500 won must equal $5, so an exchange rate of 1,300 won per dollar would be the natural one.

An exchange rate worked out by weighing how much each country's money can actually buy is called the PPP exchange rate. The well-known Big Mac Index uses exactly this idea to show, in an easy way, whether a country's exchange rate is overvalued or undervalued.

Now suppose prices in Korea suddenly double, so the hamburger costs 13,000 won, while the American burger is still $5. What happens? Korean money has lost half of its real purchasing power, so you now have to hand over 13,000 won to buy that $5 burger.

So the exchange rate has to rise from 1,300 won to 2,600 won per dollar for purchasing power in the two countries to balance out. A higher exchange rate number means the won is worth that much less. That is the core rule PPP explains: the currency of the country where prices rise faster loses value.

Using this idea, you can guess the long-run direction of exchange rates from the difference in the two countries' inflation rates. The more steadily a country keeps its prices under control, the more its money is valued over the long run compared with other currencies.

To be more precise, PPP doesn't match the market exchange rates you see in the news every day. In the real world, tariffs and expensive shipping costs get added when goods cross borders. Also, services that can't be bought and sold directly across borders (nontradable goods), such as haircuts, restaurant service, and rent, are bound to differ a lot in price from country to country.

On top of that, most of the money moving through foreign exchange markets today isn't for buying things like hamburgers. It moves because of financial deals, such as investing in stocks and bonds or chasing differences in interest rates. Sudden shocks like war or political unrest can also shake exchange rates a great deal.

So is PPP a useless theory? Not at all. Daily exchange rates bounce around like waves, but over long periods, many studies find that exchange rates tend to follow the price gap between two countries to some degree. Still, it can take several years for a gap to shrink by half, and between countries with very different income levels, differences in price levels can last a long time. PPP clears away the complicated noise and serves as a compass for judging a currency's long-term value.