- PPP theoretically links the movements in exchange rates between two countries to the changes in their currencies’ respective purchasing power.
- The Law of One Price – if there are no transportation costs, then an identical good should trade at an identical real price anywhere in the world.
- Absolute PPP – based on the law of one price, absolute PPP postulates that the spot exchange rate should reflect the price of one good compared to the other.
S X/Y = PriceX/PriceY
- Relative PPP – rooted in inflation rates, relative PPP theorizes that the future period spot rate is a function of the current spot rate (S0) and inflation (I) rates until the future spot (S1).
S 1 X/Y = S 0 X/Y ((1 + IX period)/(1 + IYperiod))
- The PPP applications assume common generalities in order to compare the currencies of vastly different economies and cannot fully explain reality.