I have blogged several short mini-lessons on the concept of "Purchasing Power Parity (PPP)" but I am never satisfied that I explained it properly. Heck, not even sure I explained it enough for ME to get it!
Here is another attempt.
Assumption #1: Today the actual market currency exchange rate in the Foreign Exchange Market is $1.00US will exchange for $1.00A ("A" is the Australian Dollar). So, the reciprocal is $1.00A will exchange for $1.00US. The currencies are at "parity" with one another--there is an even one to one trade off between the two currencies.
Assumption #2: An American decides to go on vacation to Australia to visit The Great Barrier Reef. It costs $15,000 Australian dollars to do so. An Australian decides to go on vacation to the US to visit Disney World. It costs $10,000 US dollars to do so. Everything about each vacation is the same except the experience, which we will assume yields the EXACT same satisfaction (or "utility") for the American and the Australian. They are equally happy, only in different ways.
Even though the vacations are priced differently in their respective currencies, Purchasing Power Parity suggests that buying power of one currency should be EQUAL to the buying power of the other currency when purchasing identical/similar goods and/or services. Whether that is in Australia or the US---does not matter.
Given the relative nominal prices of the vacations above, the PPP exchange rate would be $1.00 US = $1.50A and $1.00A = $.67 US.
In other words, when an America exchanges $10,000 they will receive $15,000 Australian dollars ($10,000US X $1.50A) and when an Australian exchanges $15,000A they will receive $10,000 US dollars ($15,000A X $.67US).
This is what the exchange rate SHOULD be but remember from assumption #1 the ACTUAL exchange rate is: $1.00US = $1.00A, and vice versa.
Give the actual exchange rate, the American would have to give up $15,000 US in order to get the necessary $15,000 Australian dollars for the vacation. That is $5,000 ,or 50%, MORE than at PPP!
The Australian would have to give up $10,000A to get $10,000 US. That is $5,000, or 33%, LESS than at PPP!
Because the Australian has to give up FEWER Australian dollars to buy US dollars relative to PPP, the Australian dollar is said to be OVERVALUED relative to the dollar.
Because the American has to give up MORE US dollars to buy Australian dollars relative to PPP, the US dollar is said to be UNDERVALUED relative to the Australian Dollar.
What will happen in the "Long Run" according to PPP theory?
Because American vacations are cheaper for Australians they will take more of them. This will serve increase the Supply of Australian dollar in the FOREX and depreciate the Australian dollar. The corresponding increase in Demand for Dollars will appreciate the US dollar in the FOREX.
Because Australian vacations are more expensive for Americans they will take fewer of them. This will serve to decrease the Supply of US dollars in the FOREX and appreciate the US dollar. The corresponding decrease in Demand for the Australian dollar and will depreciate the Australian dollar in the FOREX.
The exchange rates will adjust so that, all else equal, the buying power of one currency will have the same buying power of the other currency, regardless of which of the two countries a purchase is made.
That's Purchasing Power Parity (PPP) as simple as I can make it.
Hope it helps A LITTLE! :)
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