Purchasing Power Parity

Purchasing power parity (PPP) is a concept put forward by the purchasing power parity theory. According to this theory, the rate of exchange between two currencies should follow the purchasing power of those currencies.

Calculations of purchasing power parity account for purchasing power across all consumer price sectors, rather than one specific commodity (as is the case with the law of one price).

Here is a simple example: Suppose the cost of maintaining a middle-class living standard – buying groceries, paying rent on a 3.5 room apartment, taking an annual vacation and buying and maintaining a budget car – came to 3000 Swiss francs per month in Switzerland and 1500 euros per month in Italy, Germany and France.

According to PPP theory, the exchange rate between the Swiss franc and the euro should – based on this limited comparison – settle at 2 Swiss francs to 1 euro because both have the same purchasing power.

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