Purchasing Power Parity

From Forexpedia

The Purchasing Power Parity (PPP) is a theory that states that the foreign exchange rate between two countries should be equal to the ratio between their respective prices of a fixed basket of goods. When this holds true, the exchange rate is said to be in equilibrium.

For instance, if a Big Mac, fries, and a rootbeer float costs $1.80 in the US and A$2.00 in Australia, then the AUDUSD exchange rate should be 1.80/2.00 or 0.9000.

This theory is based on the Law of One Price, which says that an item should have the same price (expressed in the same currency) in different countries. Of course, this doesn't take transportation and transaction costs into account.