Purchasing Power Parity (PPP) is an economic theory that suggests exchange rates should adjust to equalize the purchasing power of different currencies. Essentially, this means that a given amount of money should buy the same quantity of goods in different countries. For example, if $1 in the United States can purchase one Coke, then exchanging that dollar for a foreign currency should allow you to buy the same Coke in that foreign country.
To illustrate this concept, consider an exchange rate of £1 to $1, where the price of a Coke is $1 in the US and £1 in the UK. In this scenario, purchasing power parity holds true because you can buy one Coke in both countries with the equivalent amount of money. However, if the price of a Coke in the UK rises to £2 while the exchange rate remains the same, purchasing power parity no longer applies. In this case, exchanging $1 for £1 would only allow you to buy half a Coke in the UK, demonstrating a disparity in purchasing power.
For purchasing power parity to be restored in this situation, the exchange rate would need to adjust to £2 per dollar. This adjustment would ensure that $1 could be exchanged for enough pounds to buy one Coke in the UK, thus equalizing purchasing power across the two currencies.
When exchange rates do not reflect changes in price levels, opportunities for profit arise through a process known as arbitrage. For instance, if you purchase 1,000,000 Cokes in the US for $1,000,000 and sell them in the UK for £2,000,000 (where the price of a Coke is £2), you could then exchange those pounds back to dollars at the original exchange rate, resulting in $2,000,000. This profit potential encourages traders to exploit discrepancies in purchasing power, which in turn drives the market toward equilibrium and restores purchasing power parity.
Ultimately, the theory of purchasing power parity emphasizes that the value of goods should remain consistent across different currencies, provided that exchange rates adjust accordingly. This principle is foundational in understanding international economics and currency valuation.