The PPP concept is based on the Law of One Price.

The PPP exchange rate is the ratio of prices between countries

Domestic prices are equal to foreign prices, converted by the exchange rate.

PPP requires domestic currency appreciation when foreign prices rise relative to domestic prices.

When exchange rates are fixed PPP requires prices to adjust to maintain parity.

1. Transportation costs
2. Taxes, import tariffs
3. Import controls, quotas and other restrictions.
4. Price index differences
5. Traded and non- traded goods
6. Capital markets and speculation more important determinant of e-rate (especially in short run)

Changes in the exchange rate reflect changes in purchasing power between countries.

%D e = %D P_d - %D P_f

Higher inflation at home than abroad should lead to domestic currency depreciation

Empirically it is clear that PPP does not hold, in either form

Exceptions are:

PPP has more support in the long run. Annual data shows less deviation from PPP than monthly data. PPP fits fairly well in the very long run (decades)

PPP fits well in periods of rapid inflation. When relative price movements are extreme they dominate the other factors that affect the exchange rate.

PPP systematically indicates that the currencies of developing countries are increasingly overvalued against the currencies of developed countries. The Balassa/ Samuelson theory explains this in terms of differences in productivity and productivity growth.

The Economists version of PPP based on the price of the Big Mac Hamburger around the world.

Surprisingly the Big Mac index has a fairly good record as a predictor of exchange rate movements