Determining Exchange Rates: The Role of Purchasing Power Parity

Every time you check the rupee-dollar rate before booking a flight or paying a tuition fee abroad, you are looking at a number that economists have spent over a century trying to explain. Why does one US dollar buy roughly 84 rupees and not 40 or 150? One of the oldest and most widely taught answers to this question is the theory of purchasing power parity (PPP). It is not a perfect explanation, but it remains the starting point for understanding how exchange rates are supposed to behave in the long run.

Why exchange rates need a theory at all 🔗

An exchange rate is simply the price of one currency expressed in terms of another. Like any price, it is influenced by demand and supply, interest rate differentials, capital flows, government intervention, and market sentiment. But economists have long searched for a more fundamental anchor, something that tells us what the exchange rate should be, even if the market rate temporarily wanders away from it. Purchasing power parity offers exactly this kind of anchor by linking exchange rates to relative price levels between countries.

The law of one price: PPP’s foundation 🔗

PPP rests on a simple idea called the law of one price. It states that in competitive markets, free of transport costs and trade barriers, an identical good should sell for the same price everywhere once prices are converted into a common currency. If a kilogram of rice is cheaper in India than in the United States after converting prices at the going exchange rate, traders would buy in India and sell in the US, pushing prices up in one market and down in the other until the gap disappears. The Saylor Academy’s international economics text explains that PPP extends this logic from a single good to an entire basket of goods and services, arguing that if the law of one price holds for individual items, it should also hold for national price levels as a whole.

Swedish economist Gustav Cassel is usually credited with formalising this idea in the early twentieth century, arguing that the value of a currency is fundamentally tied to the quantity of goods and services it can buy at home. According to a classic IMF review of PPP theory, Cassel’s contribution was to define the exchange rate as the ratio of the internal purchasing power, or price levels, of two currencies.

Absolute purchasing power parity 🔗

Absolute PPP is the simplest version of the theory. It says the exchange rate between two currencies should equal the ratio of their price levels. If a representative basket of goods costs ₹4,000 in India and the same basket costs $50 in the United States, absolute PPP predicts an exchange rate of ₹80 per dollar. The University of British Columbia’s foreign exchange resource puts this plainly: the exchange rate is equal to the price level in one country divided by the price level in the other, provided markets are competitive and the goods being compared are genuinely tradeable.

This version of PPP is elegant but demanding. It requires that the two countries’ baskets contain identical goods in identical proportions, that trade is unrestricted, and that there are no shipping costs, tariffs, or taxes distorting prices. In practice, almost none of these conditions hold perfectly, which is why absolute PPP is treated more as a theoretical benchmark than a precise predictor.

Relative purchasing power parity 🔗

Because absolute PPP is hard to test with real data, economists rely more heavily on relative PPP. Instead of comparing price levels directly, relative PPP compares changes in prices, that is, inflation rates, and links them to changes in the exchange rate over time. If India’s inflation rate is consistently higher than that of the United States, relative PPP predicts that the rupee should depreciate against the dollar by roughly that inflation differential, so that the real purchasing power of both currencies stays balanced.

The logic mirrors absolute PPP but applies it dynamically. As the Saylor Academy text notes, if domestic prices rise faster than foreign prices, the only way to preserve the law of one price on average is for the domestic currency to keep depreciating to offset the gap. This is why relative PPP is often described as a long-run relationship rather than something that holds day to day. Currency traders react within minutes to interest rate announcements or geopolitical news, but inflation differentials take years to fully show up in exchange rates.

Absolute PPP versus relative PPP 🔗

The Big Mac index: PPP made visible 🔗

One of the most popular illustrations of PPP is The Economist’s Big Mac index, first introduced in 1986. It compares the price of a McDonald’s Big Mac across countries to estimate whether currencies are overvalued or undervalued relative to the dollar. Because a Big Mac uses similar ingredients and a similar production process worldwide, it works as an informal but consistent basket of one good, offering what the original article called a way to make exchange rate theory a bit more digestible.

India does not sell a Big Mac due to dietary preferences, but McDonald’s India offers a comparable Maharaja Mac, which analysts use as a proxy. In January 2023, a Maharaja Mac cost around ₹207 while a Big Mac cost $5.36 in the United States. Dividing these figures implies a PPP exchange rate of about ₹38.6 per dollar. Since the actual market rate was above ₹81 at the time, the index suggested the rupee was undervalued by over 40 per cent on a GDP-adjusted basis. This gap illustrates exactly what PPP theory predicts should eventually correct itself, even though it clearly has not happened quickly or completely.

Why PPP does not always hold up 🔗

If PPP were a perfect description of reality, exchange rates would track inflation differentials almost exactly, and anomalies like the Big Mac gap would not exist. In practice, several frictions get in the way.

Transaction costs and trade barriers 🔗

Tariffs, shipping costs, and import restrictions all prevent the frictionless arbitrage that PPP assumes. An academic review published in Scielo Mexico notes that modern criticism of PPP centres on the implausibility of the law of one price once transport charges, taxes, and tariffs are taken into account, since these costs create a real difference between prices that arbitrage cannot fully close.

Non-tradable goods and services 🔗

National price indices include haircuts, housing, local transport, and other services that simply cannot be exported or imported. Their prices are set by local wages and demand, not by international arbitrage, so they pull a country’s overall price level away from what PPP alone would predict.

Different consumption baskets 🔗

Indian and American households do not consume the same mix of goods in the same proportions. Comparing a basket weighted heavily toward food and fuel with one weighted toward services and housing introduces distortions that have nothing to do with currency valuation.

Short-run market forces 🔗

In the short run, exchange rates are driven far more by interest rate expectations, capital flows, and news events than by inflation differentials. PPP is fundamentally a long-run theory, and testing it over short horizons tends to produce weak or inconsistent results.

Why PPP still matters despite its flaws 🔗

None of these limitations make PPP useless. Institutions such as the IMF and the World Bank use PPP-adjusted figures to compare living standards and economic output across countries in a way that raw exchange rates cannot, since market exchange rates can be volatile and do not reflect actual domestic purchasing power. For students of international economics, PPP also remains a useful diagnostic tool. When a currency deviates sharply from its PPP-implied value, as the rupee has against the dollar, it prompts deeper questions about competitiveness, subsidies, capital controls, and long-term structural gaps between economies, questions that a single exchange rate number cannot answer on its own.

What do you think? If the rupee is genuinely undervalued relative to its purchasing power, why might it stay that way for years instead of correcting quickly? And when comparing living standards between India and a developed economy, does a PPP-adjusted number tell a more honest story than the market exchange rate, or does it hide problems of its own?

References

1. https://saylordotorg.github.io/text_international-economics-theory-and-policy/s20-purchasing-power-parity.html
2. https://www.elibrary.imf.org/view/journals/024/1976/001/article-A001-en.xml
3. https://fx.sauder.ubc.ca/PPP.php
4. https://public.websites.umich.edu/~kathrynd/burgernomics.pdf
5. https://www.business-standard.com/amp/article/finance/big-mac-index-suggests-rupee-is-undervalued-by-over-40-relative-to-dollar-123012701063_1.html
6. https://www.scielo.org.mx/scielo.php?script=sci_arttext&pid=S0185-16672022000400003