Purchasing Power Parity (PPP) is a fundamental economic theory that measures the relative value of different currencies. It is based on the "Law of One Price," which suggests that in an efficient market, identical goods should cost the same price when expressed in a common currency.
The PPP Formula
The calculation for the PPP exchange rate is straightforward:
S = P1 / P2
Where:
S: Exchange rate of currency 1 to currency 2.
P1: Cost of a specific good in currency 1.
P2: Cost of the same specific good in currency 2.
Realistic Example: The "Burger" Index
Suppose a specific burger costs 600 Yen in Japan and $5.00 in the United States. According to the PPP theory, the implied exchange rate should be 120 Yen per 1 USD (600 / 5 = 120).
If the actual market exchange rate is 140 Yen per 1 USD, the Yen is considered undervalued by approximately 14.3%. This suggests that your purchasing power in Japan is higher than what the market exchange rate implies.
Why Does PPP Matter?
PPP is vital for international comparisons of Gross Domestic Product (GDP) and standards of living. Using market exchange rates can be misleading because they fluctuate based on interest rates, speculation, and capital flows. PPP provides a more stable, long-term view of a currency's "true" value based on what it can actually buy.
function calculatePPP() {
var localPrice = parseFloat(document.getElementById('localPrice').value);
var referencePrice = parseFloat(document.getElementById('referencePrice').value);
var marketRate = parseFloat(document.getElementById('marketExchangeRate').value);
var resultsDiv = document.getElementById('ppp-results-container');
var impliedPPPDisplay = document.getElementById('impliedPPPRate');
var statusDisplay = document.getElementById('valuationStatus');
var messageDisplay = document.getElementById('valuationMessage');
if (isNaN(localPrice) || isNaN(referencePrice) || localPrice <= 0 || referencePrice 0) {
// Calculate valuation percentage
// ((PPP – Market) / Market) * 100
var valuation = ((impliedPPP – marketRate) / marketRate) * 100;
var valuationFixed = Math.abs(valuation).toFixed(2);
if (valuation > 0) {
statusDisplay.innerText = "Overvalued by " + valuationFixed + "%";
statusDisplay.style.color = "#e74c3c";
messageDisplay.innerText = "The local currency is overvalued compared to the reference currency according to the Law of One Price. This means goods in the local country are relatively more expensive.";
} else if (valuation < 0) {
statusDisplay.innerText = "Undervalued by " + valuationFixed + "%";
statusDisplay.style.color = "#27ae60";
messageDisplay.innerText = "The local currency is undervalued compared to the reference currency. This suggests higher purchasing power locally than the market exchange rate would indicate.";
} else {
statusDisplay.innerText = "At Parity (Correctly Valued)";
statusDisplay.style.color = "#2980b9";
messageDisplay.innerText = "The market exchange rate matches the purchasing power parity exactly.";
}
} else {
statusDisplay.innerText = "Market Rate Not Provided";
statusDisplay.style.color = "#7f8c8d";
messageDisplay.innerText = "Enter a market exchange rate to see if the currency is overvalued or undervalued.";
}
resultsDiv.style.display = 'block';
}