Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries’ price level of a fixed basket of goods and services. When a country’s domestic price level is increasing (i.e., a country experiences inflation), that country’s exchange rate must depreciated in order to return to PPP.
The basis for PPP is the “law of one price”.
Purchasing power parity is used worldwide to compare the income levels in different countries. PPP thus makes it easy to understand and interpret the data of each country.
Example: Let’s say that a pair of shoes costs Rs 2500 in India. Then it should cost $50 in America when the exchange rate is 50 between the dollar and the rupee.
What happens if not in parity?
Indian consumers will go to the exchange office and sell their INR and buy USD, and then buy the laptop from USA. It will cause the Indian currency less valuable than the US dollar.
The demand of laptop sold in India will decrease (since high price), and the price of laptop will go down. In contrast, the demand of laptop in USA will increase, and the price will rise accordingly.
These factors will cause the exchange rate (of the currencies) and the prices (of laptops) to change such that there is purchasing power parity in both the currencies.
Long term effect
PPP theory tells us that the price differences between countries are not sustainable in the long run, as market forces will equalize prices between the countries and change the exchange rates accordingly.
(Relate the above example with companies that can buy goods in much less price from foreign countries and sell in much less price in India than its counterparts. For this reason, there are several laws or restrictions on imports and a provision of levying customs duty, etc.)