purchasing power parity - Investment & Finance Definition
The theory that exchange rates will adjust to equalize the relative purchasing power among currencies. The theory is based on the law of one price, which says that in competitive markets, identical goods will sell for identical prices when valued in the same currency.
PPP says that in the absence of costs, such as transportation or other costs, markets that have competition will equalize the price of identical goods in two countries when the prices are in the same currency. For example, a stereo that sells for 750 Canadian dollars in Canada should cost $500 in the United States, when the exchange rate between Canada and the U.S. is 1.50 CAD/USD.
While PPP is a useful theory, it has its shortcomings. It assumes that all goods are identical, tradable, and have no taxes or transportation costs that affect the relative value. It also assumes that exchange rates are influenced only by inflation rates, which is incorrect.