Purchasing power parity

Purchasing power parity (PPP) is a theory that tries to work out how over- or undervalued one currency is in relation to another. It does this by comparing the price of two identical goods in different economies.

Say, for example, a Mars bar costs 70p in Britain and the identical product costs $1 in America. The theory suggests that the exchange rate between sterling and the US dollar should be about 1.43 – i.e, £1 buys you about $1.43 (since 70p x 1.43 is roughly 100c, or $1).

So if, in fact, the exchange rate is, say, 1.60, then sterling is overvalued relative to the US dollar. It suggests that either sterling will weaken or the dollar should strengthen.

The problem with using PPP this way is that it makes quite a few assumptions, mainly that the input costs (raw materials, labour and so on) are equal for something like a Mars bar, no matter where it is sold.

Merryn

Claim 12 issues of MoneyWeek (plus much more) for just £12!

Let MoneyWeek show you how to profit, whatever the outcome of the upcoming general election.

Start your no-obligation trial today and get up to speed on:

  • The latest shifts in the economy…
  • The ongoing Brexit negotiations…
  • The new tax rules…
  • Trump’s protectionist policies…

Plus lots more.

We’ll show you what it all means for your money.

Plus, the moment you begin your trial, we’ll rush you over THREE free investment reports:

‘How to escape the most hated tax in Britain’: Inheritance tax hits many unsuspecting families. Our report tells how to pass on up to £2m of your money to your family without the taxman getting a look in.

‘How to profit from a Trump presidency’: The election of Donald Trump was a watershed moment for the US economy. This report details the sectors our analysts think will boom from Trump’s premiership, and gives specific investments you can buy to profit.

‘Best shares to watch in 2017’: Includes the transcript from our roundtable panel of investment professionals – and 12 tips they’re currently tipping. The report also analyses key assets, including property, oil and the countries whose stock markets currently offer the most value.