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.