Purchasing Power Parity

Purchasing Power Parity (PPP) is an economic theory that compares different countries' currencies through a basket of goods approach, suggesting that exchange rates should adjust so that identical goods cost the same in different countries. It is used to compare living standards and economic productivity across nations. In forex markets, PPP is one of several factors used to assess whether a currency is overvalued or undervalued.

If a basket of goods costs $100 in the United States and the equivalent basket costs £80 in the United Kingdom, PPP theory suggests the GBP/USD exchange rate should be 1.25. If the market rate is significantly different, the currency may be considered over or undervalued. Forex traders and macro investors use PPP as a long-term reference point when building directional views on currency pairs, though short-term exchange rates can deviate substantially from PPP due to interest rate differentials, capital flows, and market sentiment.