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.

MoneyWeek magazine

Latest issue:

Magazine cover
Don't be spooked by Putin

Take a punt on eastern Europe

The UK's best-selling financial magazine. Take a FREE trial today.
Claim 4 FREE Issues
Shale gas 'fracking' promises to transform Britain's energy market. Find out what it is, what it means, and how to invest.

More from MoneyWeek

FREE REPORT:
What you should really do with your money (2014 Edition)


How to buy and sell penny shares

A beginner's guide to investing in gold

How to invest in British fracking

Which investment platform?

When it comes to buying shares and funds, there are several investment platforms and brokers to choose from. They all offer various fee structures to suit individual investing habits.
Find out which one is best for you.