Glossary

Purchasing power parity (PPP)

A theory that exchange rates should adjust so identical goods cost the same amount across countries once converted to a common currency.

Also called: PPP

Purchasing power parity (PPP) holds that, in the long run, exchange rates should adjust so the same basket of goods costs the same amount in any country once prices are converted to a common currency. If a basket costs more in one country after conversion, PPP predicts the exchange rate will eventually move to close that gap.

Absolute PPP compares price levels directly, as in the widely cited Big Mac Index. Relative PPP instead compares inflation rates between two countries and predicts the exchange rate should move to offset the difference, loosely expected FX change ≈ inflation(home) - inflation(foreign). This differs from a real effective exchange rate, which measures how far a currency currently sits from a PPP-consistent level against a trade-weighted basket, rather than predicting where it is headed.

PPP is used to compare living standards and output across countries on a more meaningful basis than market exchange rates, and as a long-horizon anchor for currency valuation. The common misreading is expecting PPP to explain short-term moves: currencies can deviate from PPP for years because of capital flows, carry trade activity, trade barriers, and non-tradable goods like housing, which are never arbitraged across borders.

Last reviewed September 22, 2026

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Related terms

Real effective exchange rate (REER) A currency's exchange rate against a trade-weighted basket of other currencies, adjusted for relative inflation. Consumer price index (CPI) A measure of the average change in prices paid by consumers for a fixed basket of goods and services. Carry trade Borrowing in a low-interest-rate currency to invest in a higher-yielding one, profiting from the rate gap unless the exchange rate moves against it. Forward points The difference between a currency's spot and forward exchange rate, driven by the interest rate gap between the two currencies.

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