Purchasing power parity and exchange rates

¶ … purchasing power parity (PPP) states that the exchange rate between two currencies is related to the relative prices in the two countries so that exchange rate-adjusted prices will be equal between the two countries (Norrbin, and Conover).

(Dryden, Reut, and Slater) further stated that, as purchasing power parities (PPP's) are nothing more than interspatial price indexes (by analogy with the inter-temporal price indexes such as consumer price indexes), the methodology, and theory underlying their calculation are identical to those of index numbers that are more familiar. Just as consumer price indexes can be used to compare purchasing power in the same place at different times, PPP's compare purchasing power in different places at the same time.

Consequently, a system of purchasing power parities was developed to reflect the rate at which one currency could be converted to another to purchase equivalent goods and services in both countries. This system not only makes it possible to compare real levels of gross domestic product between countries, rather than nominal levels (which would be obtained if the data were converted using exchange rates). A system of purchasing power parities can also be used to compare real levels of personal and government consumption and gross fixed capital formation, as well as smaller expenditures such as for food, housing, and construction (Dryden, Reut, and Slater).