Purchasing Power Parity (PPP) is an economic theory stating that exchange rates should adjust so identical goods cost the same when converted to a common currency. If a basket of goods costs $100 in the US and £80 in the UK, PPP predicts the pound should trade at 0.80 USD, based on actual purchasing power rather than market sentiment. Over the long term, currencies tend toward this equilibrium, though short-term fluctuations often diverge significantly.
PPP comes in two forms: Absolute PPP says exchange rates equal the ratio of price levels between countries right now. Relative PPP suggests that currency changes should reflect inflation differences—if the US inflates 3% and the UK inflates 1%, the pound should appreciate 2% to maintain parity. Neither holds perfectly in real markets because of transaction costs, trade barriers, and different consumption baskets across countries.
For forex traders, PPP offers a long-term fair value anchor. If a currency trades far below its PPP level, mean reversion toward PPP may eventually occur, though "eventually" can mean years. Short-term moves are driven by interest rates, sentiment, and central bank policy, not PPP. Use PPP to contextualize which currencies are overvalued or undervalued on a multi-year horizon, not for tactical trading decisions.
