Purchase Parity Calculator

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Reviewed by: Dr. David Chen, PhD, Economist

Use this Purchasing Power Parity (PPP) Calculator to estimate the theoretical exchange rate between two currencies based on the price of an identical basket of goods. Compare the result with the actual exchange rate to determine if a currency is undervalued or overvalued.

Purchasing Power Parity Calculator

PPP Exchange Rate ($E_{ppp}$)

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Purchasing Power Parity Formula

$$E_{ppp} = \frac{P_f}{P_d}$$

$$Valuation (\%) = \frac{E_{actual} – E_{ppp}}{E_{ppp}} \times 100$$

Formula Sources: IMF, Investopedia

Variables

  • Domestic Price ($P_d$): The cost of a standardized basket of goods in the domestic country (e.g., U.S.).
  • Foreign Price ($P_f$): The cost of the identical basket of goods in the foreign country (e.g., Japan).
  • Actual Exchange Rate ($E_{actual}$): The current, observed market exchange rate (units of Foreign Currency per 1 unit of Domestic Currency).
  • PPP Exchange Rate ($E_{ppp}$): The theoretical exchange rate calculated under PPP.

Related Calculators

What is Purchasing Power Parity?

Purchasing Power Parity (PPP) is an economic theory that states that the exchange rate between two countries’ currencies is equal to the ratio of the countries’ price levels of a goods basket. The PPP rate is the rate at which the currency of the second country would have to be exchanged for that of the first in order to purchase the same amount of goods or services in each country.

The theory is based on the law of one price, which argues that, in the absence of transaction costs and trade barriers, identical goods should sell for the same price in different countries. While PPP rarely holds true in the short term due to factors like transportation costs, tariffs, and non-tradable goods, it is often considered a reliable long-term indicator for currency valuation and economic comparison.

How to Calculate PPP (Example)

Imagine a Big Mac costs \$5.00 in the U.S. and ¥800 in Japan. The actual exchange rate is ¥150 per \$1.

  1. Determine the Prices: $P_d$ (Domestic Price, USD) = 5.00. $P_f$ (Foreign Price, JPY) = 800.00.
  2. Apply the PPP Formula: $$E_{ppp} = P_f / P_d = 800 / 5 = 160.00$$
  3. Interpret the Result: The PPP Exchange Rate is ¥160 per \$1. This means the theoretical exchange rate should be 160 JPY/USD for the purchasing power to be equal.
  4. Calculate Valuation: Compare $E_{ppp}$ (160) with $E_{actual}$ (150). $$\text{Valuation} (\%) = \frac{150 – 160}{160} \times 100 \approx -6.25\%$$
  5. Conclusion: Since the yen buys fewer dollars in the market (150) than it should theoretically (160), the JPY is undervalued by approximately 6.25% against the USD.

Frequently Asked Questions (FAQ)

Q: Why is the actual exchange rate different from the PPP exchange rate?

A: The PPP theory assumes perfect conditions, which rarely exist. Real-world deviations are caused by non-tradable goods (like haircuts), transportation costs, tariffs, different tax structures, and speculative currency trading.

Q: Is PPP only used for currency valuation?

A: No. Economists also use PPP rates to adjust Gross Domestic Product (GDP) figures. This allows for a more accurate comparison of living standards and economic output across different countries by eliminating currency differences.

Q: What is the Big Mac Index?

A: The Big Mac Index, published by The Economist, is a famous, informal application of the PPP theory. It compares the price of a Big Mac hamburger across countries to gauge currency valuation against the U.S. dollar.

Q: How does this calculator handle missing inputs?

A: This calculator requires both the Domestic Price ($P_d$) and Foreign Price ($P_f$) to determine the PPP Exchange Rate ($E_{ppp}$). The Actual Exchange Rate ($E_{actual}$) is optional, but necessary to determine the percentage of over or undervaluation.

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