If there exists any deviation from this equilibrium situation then movements in the exchange rate and relative prices work towards restoring the equilibrium situation. (However, for this prices need to be expressed in the same currency).Įconomists make use of two types of purchasing power parity.Ībsolute PPP implies that an identical consumption basket ought to cost the same in any two countries. It states that in the absence of transaction costs including transportation costs, competitive markets tend to equalize the price of a representative and identical commodity in two nations. In case a country’s price level rises due to inflation its exchange rate needs to be depreciated to maintain PPP. Purchasing power parity ( PPP) theory states that currency exchange rates are at equilibrium when their respective purchasing powers are same (in each of two nations). Thus Big Mac Index provides an indication of overvaluation or undervaluation of currencies. Big Mac index enables economists to make exchange rates comparisons and comparisons of relative prices among countries, worldwide. Big Mac PPP is that exchange rate, which makes the price of a hamburger in any country same as that (prevalent) in the USA. In this particular case, a Big Mac replaces that representative consumption basket. It involves the concept of ‘purchasing-power-parity’ in economics. Purchasing power parity (PPP) theory states that ultimately exchange rates between nations should attain a level where an identical consumption basket (comprising goods and services) would display same price in concerned nations. It was introduced by Economist magazine in 1986.
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