Purchasing Power Parity (PPP) represents a fundamental factor that is a driver of the movement of a currency on the forex market. PPP states that there is a relationship between currency rates and the price at which different goods and services are sold. In order to calculate the value of PPP, apply the following formula:
Exchange Rate = Price of Goods in Country X / Price of Goods in Country Y
The calculations for PPP should be based on the prices of a basket of goods and services, which includes:
- Consumer goods and services
- Equipment goods
- Construction projects
- Government services
A fixed basket of goods and services should be used in order to compare the exchange rates of the currencies of two countries. The corresponding exchange rate should be equal to the price level of this basket.
Arbitrage is the term used when different prices of one and the same product occur in two countries. Thus, in order to adjust for the arbitrage currencies should decrease in value under the conditions of rising prices (inflation).
By applying PPP principles, the prices in two countries of one product should be compared in order to determine the exchange rate. If the current market rate is greater than the calculated exchange rate, then this exchange rate should decrease in value so that it matches to the value of PPP. The opposite is true if the current market rate is less than the calculated exchange rate.
As a major source of PPP values you can use the regular publications of the Organization for Economic Cooperation and Development (OECD).
PPP is used as the basic tool for translating GDP into common currency, which facilitates the comparison between two countries.
PPP doesn’t take into account fluctuations that occur over the short term. Additionally, PPP fails to consider such factors as different tax regulations and trade restrictions applied by some countries. Thus, you should keep in mind when using PPP that its results are best for long term currency analysis.