Pacific Exchange Rate Service

Sauder School of Business • University of British Columbia

A service for academic research and teaching provided by Prof. Werner Antweiler at UBC's Sauder School of Business since 1996.

Purchasing Power Parity

What is Purchasing Power Parity?

Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When a country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must depreciated in order to return to PPP.
   The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency. For example, a particular TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver. If this process (called "arbitrage") is carried out at a large scale, the US consumers buying Canadian goods will bid up the value of the Canadian Dollar, thus making Canadian goods more costly to them. This process continues until the goods have again the same price. There are three caveats with this law of one price. (1) As mentioned above, transportation costs, barriers to trade, and other transaction costs, can be significant. (2) There must be competitive markets for the goods and services in both countries. (3) The law of one price only applies to tradeable goods; immobile goods such as houses, and many services that are local, are of course not traded between countries.
   Economists use two versions of Purchasing Power Parity: absolute PPP and relative PPP. Absolute PPP was described in the previous paragraph; it refers to the equalization of price levels across countries. Put formally, the exchange rate between Canada and the United States E_CAD/USD is equal to the price level in Canada P_CAN divided by the price level in the United States P_USA. Assume that the price level ratio P_CAD/P_USD implies a PPP exchange rate of 1.3 CAD per 1 USD. If today's exchange rate E_CAD/USD is 1.5 CAD per 1 USD, PPP theory implies that the CAD will appreciate (get stronger) against the USD, and the USD will in turn depreciate (get weaker) against the CAD.
   Relative PPP refers to rates of changes of price levels, that is, inflation rates. This proposition states that the rate of appreciation of a currency is equal to the difference in inflation rates between the foreign and the home country. For example, if Canada has an inflation rate of 1% and the US has an inflation rate of 3%, the US Dollar will depreciate against the Canadian Dollar by 2% per year. This proposition holds well empirically especially when the inflation differences are large.

Does PPP determine exchange rates in the short term?

No. Exchange rate movements in the short term are news-driven. Announcements about interest rate changes, changes in perception of the growth path of economies and the like are all factors that drive exchange rates in the short run. PPP, by comparison, describes the long run behaviour of exchange rates. The economic forces behind PPP will eventually equalize the purchasing power of currencies. This can take many years, however. A time horizon of 4-10 years would be typical.

How is PPP calculated?

The simplest way to calculate purchasing power parity between two countries is to compare the price of a "standard" good that is in fact identical across countries. Every year The Economist magazine publishes a light-hearted version of PPP: its "Hamburger Index" that compares the price of a McDonald's hamburger around the world. More sophisticated versions of PPP look at a large number of goods and services. One of the key problems is that people in different countries consumer very different sets of goods and services, making it difficult to compare the purchasing power between countries.

According to PPP, by how much are currencies overvalued or undervalued?

The following charts compare the PPP of a currency with its actual exchange rate relative to the US Dollar, the Canadian Dollar, and the European Euro, respectively. The charts are updated periodically to reflect the current exchange rate. It is also updated once a year to reflect new estimates of PPP. The PPP estimates are taken from studies carried out by the Organization of Economic Cooperation and Development (OECD) and others; however, they should not be taken as "definitive". Different methods of calculation will arrive at different PPP rates.
   The currencies listed below are compared to the US Dollar. A green bar indicated that the local currency is overvalued by the percentage figure shown on the axis; the currency is thus expected to depreciate against the US Dollar in the long run. A red bar indicates undervaluation of the local currency; the currency is thus expected to appreciate against the US Dollar in the long run.

How has PPP developed over time for major currencies?

The next set of charts shows how purchasing power parity has developed for major currencies since 1972, the first year after the collapse of the Bretton Woods system of fixed exchange rates. For currency pairs involving the European Euro, the diagrams start in 1999 when the Euro was launched. The charts on the left show the annual average exchange rate (red) and the purchasing power parity calculated by the OECD (blue). Whenever the red line is above the blue line, the currency is overvalued against its peer, and when the red line is below the blue line the currency is undervalued.
   Have a look at the first chart that shows PPP for the Canadian Dollar relative to the US Dollar. Between 1992 and 2004 the Canadian Dollar was significantly undervalued, and between 2004 and 2014 it was overvalued. The charts on the right show the levvel of overvaluation and undervaluation in percent. From this you can see that the Canadian Dollar was undervalued as much as 20 percent (in 2002) and overvalued by as much as 25 percent (in 2011 and 2012).
   The diagrams below cover a number of currency pairs: CAD/USD, EUR/USD, GBP/USD, JPY/USD as well as GBP/EUR and CAD/EUR. Academic users of the Pacific Exchange Rate Service may email me to request additional currency pairs should these be needed for teaching or research purposes.

How often are these charts updated?

The purchasing power parity charts for 20 currencies relative to the US Dollar, Canadian Dollar, British Pound, and Euro are updated every weekday. The annual charts for the historic time series are updated weekly (every Tuesday) but will only change when the OECD releases their latest data (which should be caught within a week or two). As the update system is fully automated, please email me if you spot any errors or glitches.

Where can I get more information?

The main sources of PPP data (also used in the charts above) is the OECD web site Prices and purchasing power parities (PPP). From there you can navigate to their data page Purchasing Power Parities (PPPs), data and methodology, and specifically to their data set. Note that their data set is due to be migrated to a new OECD Data Explorer platform (Feb. 2024).
   From The Economist magazine comes the The Big Mac Index, a widely used quick indicator of PPPs aroudn the world since 1986. "Burgernomics" has spawned much related research and has been influential in policy discussions as well, despite the obvious limitations of this metric.

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