According to the Purchasing Power Parity (PPP) Theory of exchange rates, currencies should adjust so that the prices of a similar basket of goods costs the same in different countries and is used to examine whether a currency is currently over or under-valued. If the current exchange rate between sterling and the US dollar is £1 = $1.50, we would expect that if a basket of goods cost £100 in the UK it should cost $150 in the USA . However, if the basket only cost $100, travellers from the UK to the USA would find that their pounds, when converted into dollars, were buying more in New York than they could purchase in London and sterling was overvalued.
The PPP exchange rate is also used when comparing living standards in different countries. GDP per capita is the most common method but there is a problem with the exchange rate. The UK GDP is measured in sterling while the US uses dollars. If the exchange were stable AND reflected the prices of goods in the two countries, there would not be a problem. However this is not the case. As an illustration, consider that the £:$ exchange rate has fluctuated between £1 = $1.49 in 2016 and £1 = $1.25 in 2019. Depending on when one made the comparison, it might look as if the UK standard of living had fallen significantly over the three-year period. Therefore, using a PPP exchange rate, which uses the cost of similar baskets of goods, avoids the problem of a fluctuating exchange rate.
The use of PPP exchange rates can have a significant impact when looking at a country’s income. In India, the predicted GDP per head for 2020 rose from $2,500 per person to $8,900 when a PPP measure was used, indicating that goods and services there were cheap and the Indian rupee was significantly more valuable than indicated by the exchange rate while in Norway predicted GDP per head fell from $79,000 to $69,000, showing that goods are services in Norway were relatively expensive.
However PPP’s use brings different problems. Calculating the cost of a comparable basket of goods is a complex process – think what you might have for breakfast at home compared to what you would eat in France. Since 1986 The Economist has published its own, non-scientific, PPP measure based on the price of a Big Mac in different countries. (An alternative to the Big Mac particularly in countries where the eating of beef is not common is the Starbucks Grande Latte Index). The Big Mac Index is useful as a quick guide to whether or not a currency is over or under-valued. Last year a Big Mac cost $5.58 in the USA but SFr6.50 or $6.62 indicating that the Swiss franc was overvalued by almost 20%. However if you wanted to fill up on Big Macs, the best place would have been Russia where it cost 110 roubles or $1.65, showing that the rouble was significantly under-valued.
The PPP is not an accurate predictor of short-term changes in exchange rates since speculation and interest rate changes can move currencies quickly. However, over a long period, the concept is valid. According to The Economist, currencies which, according to the Big Mac Index, were undervalued, appreciated over a 10 year period and vice versa.