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.
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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.
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