The law of one price
With no transport costs or tariffs and free trade, an identical good should cost the same in every country once prices are converted into one currency, because any gap would be closed by arbitrage: buy where it is cheap and sell where it is dear. This is the law of one price, and purchasing power parity extends it from single goods to whole price levels.
Cassel's formulation and the two forms
The Swedish economist Gustav Cassel set out the theory around the end of the First World War, when price levels had diverged sharply, including in a 1918 article.
- Absolute PPP: exchange rate = domestic price level ÷ foreign price level. The same basket of goods should cost the same in both countries once converted.
- Relative PPP: the rate of change of the exchange rate ≈ domestic inflation − foreign inflation. The currency of the country with faster inflation loses value accordingly.
The Big Mac index and PPP conversion rates
Since 1986 The Economist has published the Big Mac index, comparing the price of a McDonald's Big Mac around the world. Comparing the exchange rate implied by burger prices with the actual rate gives a light-hearted gauge of whether a currency is over- or undervalued. For more rigorous work, the World Bank's International Comparison Program (ICP) surveys prices of a wide range of goods and services to compute PPP conversion factors, which are used to compare countries' GDP in terms of purchasing power.
Why it often fails in practice
- Transport costs, tariffs and trade barriers limit arbitrage.
- Non-traded goods and services, such as haircuts, restaurant meals and housing, cannot be traded across borders.
- Price indices use different baskets and weights in different countries.
- Short-run exchange rates are driven largely by capital flows, interest-rate differentials and expectations.
The Balassa–Samuelson effect (1964) explains why richer countries have higher price levels: higher productivity in their traded-goods sectors raises wages, which pushes up prices of non-traded goods too. Currencies of rich countries therefore tend to look overvalued on a PPP basis.
The PPP puzzle and assessment
Rogoff (1996) summarized evidence that real exchange rates return to PPP very slowly, with deviations having a half-life of roughly three to five years, and called this the "PPP puzzle". PPP is therefore used more as a long-run anchor than as a short-run forecasting tool. Other approaches, such as interest rate parity and Goschen's balance-of-payments view, are compared in exchange rate determination theories.
Sources reviewed: 2026-10-16
References
- Cassel, G. (1918). Abnormal deviations in international exchanges. Economic Journal, 28(112), 413–415.
- Balassa, B. (1964). The purchasing-power parity doctrine: A reappraisal. Journal of Political Economy, 72(6), 584–596.
- Samuelson, P. A. (1964). Theoretical notes on trade problems. Review of Economics and Statistics, 46(2), 145–154.
- Rogoff, K. (1996). The purchasing power parity puzzle. Journal of Economic Literature, 34(2), 647–668.