In an era of floating and occasionally volatile exchange rates, estimating the long run value of currencies is no easy feat. The concept of purchasing power parity (PPP), however, offers one way through which investors and traders can consider currency valuations. PPP is the exchange rate that equalizes, or brings to par, relative differences in price levels across countries. Such a rate can often deviate from market exchange rates in the short-term, but is helpful in determining the course of long-run foreign exchange rates. And while market rates are a function of financial flows across countries, PPP looks deeper, accounting for the comparative prices in different countries of a basket of internationally traded goods. The Organisation for Economic Co-operation and Development (OECD) definition of PPP used here, for example, is determined in stages – first at the product level (e.g., a Big Mac), then the product group level (fast food restaurants), and then at aggregated levels (food), all the way up to GDP.1 The chart below brings both market exchange rates and the concept of PPP together. A currency’s under or overvaluation is determined by whether the PPP ratio of price levels is greater or less than the market spot rate.
1 OECD, 2017