Purchasing power parity

The purchasing-power parity (also known as PPP) theory states that a unit of any currency should purchase the same amount of goods in all countries. In the long run this theory may explain the behaviour of exchange rates.

The base of the purchasing-power parity theory is the law of one price. This principle asserts that a product should be sold at the same price in all markets, otherwise arbitrage opportunitiesappear and individual actions push prices to a point where they become equal again.

When using this theory we can conclude that, in the long run, real exchange rates are constant over time. Conversely, nominal exchange rates depend on the price levels in both countries. However, in the real world, exchange rates fluctuate not only due to changes in the price levels: the purchasing-power parity theory has constraints. These limitations are mainly that some products are not easily traded, and even if tradable, some goods are not perfect substitutes if they are produced in different locations.