"Purchasing Power Parity for Dummies"---like me!

Purchasing Power Parity is somewhat of a difficult concept to grasp for the average high school student. Heck, I struggle with it.

I will try to make it as easy as possible with my explanation here. Sort of my personal "Purchasing Power Parity for Dummies".

Let's say we have a shopping list of various goods and services that are available in the US and in the European Union and these goods and/or services are identical in every way.  People in the US and the EU buy these items on a regular basis so they are important for daily/weekly/monthly consumption.

We have two baskets. One basket, "Basket 1", is labeled purchased in the USA and the other basket, "Basket 2", is labeled purchased in the European Union.   Let's go shopping!

The items in Basket 1 (USA) total $150.00 and are purchased using US dollars.  The items in Basket 2 (EU) total 100 Euros and are purchased using Euros.

What if me and my European friend wanted to change places--- I buy my stuff in Europe and he buys his in the US.  The first thing I would have to do is exchange my US Dollars into Euros and he would have to exchange his Euros into Dollars.  What would be the exchange rate so that we could buy the SAME goods and services as we did before?

Ratios, man, Ratios.

If you divide the value of Basket 2 (100 Euros) by the value of Basket 1 ($150)---100 Euros/$150--- we get an exchange rate .67 Euros cents PER dollar exchanged.  Meaning, for every dollar I exchange for Euros I get .67 Euro cents.  So in order for me to get the requisite 100 Euros to buy my basket of goods in Europe I will need to exchange $150 US dollars to do so ($150 X .67 Euros = 100 Euros).

The reciprocal is going to be true for my European friend.

If you divide the value of Basket 1 ($150) by the value of Basket 2 (100 Euros)---$150/100 Euros---we get and exchange rate of $1.50 PER Euro exchanged.  Meaning, for every Euro my friend exchanges for Dollars, he will get $150.  So in order to get the requisite $150 to buy his basket of goods in the US he will need to exchange 100 Euros to do so (100 Euros X $1.50 = $150 US dollars).

Purchasing Power Parity (PPP) is defined as:

Purchasing-power parity theory. A theory which states that the exchange rate between one currencyand another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent.

In short, what this means is that a bundle of goods should cost the same in Canada and the United States once you take the exchange rate into account. 

The exchange rate I calculated above would be the Purchasing Power Parity Exchange Rate.

Again, that is: $1.00 US = .67 Euros and/or 1.00 Euro = $1.50.  At this exchange rate, me and my friend can buy our basket of stuff in each others country and our currency will have the SAME purchasing power regardless if it is in Dollars or Euros.

Purchasing Power Parity is basically a reference point as to where exchanges rate SHOULD BE in the Long Run.  For the most part, the ACTUAL exchange rate between to currencies varies from the PPP exchange rate.

Today the exchange rate between the Dollar and the Euro is ACTUALLY:

$1.00 = .73 Euro cents and 1.00 Euro = $1.37 

 Compared to the PPP exchange Rate we calculated above:

$1.00 =.67 Euros cents and 1.00 Euro = $1.50

At today's exchange rate I can get .73 Euro cents per dollar exchanged which is $.06 cents more than PPP suggests.  So, for a holder of US dollars that basket of stuff is LESS EXPENSIVE to buy (I get MORE Euro cents than at PPP so the Euro basket costs me less).

For my European friend at today's exchange rate he can get only $1.37 per Euro exchanged which is .13 cents less than PPP suggests. So, for a holder of Euros that basket of stuff is MORE EXPENSIVE to buy (he gets FEWER cents than at PPP so the US basket costs him more).

This suggests, with my example, that the US dollar is OVER-VALUED compared to the Euro and the Euro is UNDER-VALUED compared to the US dollar, relative to the PPP exchange rate.

In the long run, according to PPP theory, the Dollar should depreciate in value and the Euro should appreciate in value so that the currencies used to purchase the stuff in the respective market baskets will have the same purchasing power.

Hope this helps somewhat.  Let me know if I went wrong anywhere---remember I am one of the Dummies myself.  :)