Purchasing Power Parity

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Purchasing power parity (PPP) is a theory of long-term equilibrium exchange rates based on relative price levels of two countries. The idea originated with the School of Salamanca in the 16th century and was developed in its modern form by Gustav Cassel in 1918. The concept is founded on the law of one price; the idea that in absence of transaction costs, identical goods will have the same price in different markets.

In its "absolute" version, the purchasing power of different currencies is equalized for a given basket of goods. In the "relative" version, the difference in the rate of change in prices at home and abroad—the difference in the inflation rates—is equal to the percentage depreciation or appreciation of the exchange rate.

Deviations from the theory imply differences in purchasing power of a "basket of goods" across countries, which means that for the purposes of many international comparisons, countries' GDPs or other national income statistics need to be "PPP adjusted" and converted into common units. The best-known purchasing power adjustment is the Geary–Khamis dollar (the "international dollar").

Real exchange rate fluctuations are mostly due to different rates of inflation between the two economies. Aside from this volatility, consistent deviations of the market and purchasing power adjusted exchange rates can be observed, for example (market exchange rate) prices of non-traded goods and services are usually lower in countries with lower incomes (a U.S. dollar exchanged and spent in India will buy more haircuts than a dollar spent in the United States).