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International Financeintermediate

Exchange Rates in the Long Run: Purchasing Power Parity

Over the long run, exchange rates move toward purchasing power parity (PPP). PPP applies the law of one price to whole economies, so if a country’s price level rises faster than another’s, its currency tends to depreciate to keep a basket of goods costing about the same across borders.

Try it yourself

Purchasing power parity

Absolute PPP sets the exchange rate to the ratio of price levels: E_PPP = P_dom / P_for. The real exchange rate q = E_market · P_for / P_dom equals 1 at PPP, so any gap is over- or under-valuation.

Quote convention: E = domestic currency per 1 unit of foreign currency. A higher E means the domestic currency has depreciated.

PPP-implied rate E_PPP1.00dom / foreign
Domestic currency isat PPPq = 1.00
0.00.51.01.52.00.00.51.01.52.0Price ratio P_dom / P_for (index ÷ index)Exchange rate E (dom / foreign)E_PPP 1.00E_market 1.00PPP line (slope 1)Market rate
Real exchange rate q 1.00Market vs PPP +0.0%
Domestic price level P_dom100
Foreign price level P_for100
Market exchange rate E_market1.00
The market rate sits exactly on the PPP line, so q = 1 and the domestic currency is fairly valued against PPP. Raise P_dom and watch E_PPP rise: domestic inflation depreciates the currency.
Relative PPP. Over time the rate moves with the inflation gap: %ΔE ≈ pi_dom − pi_for, exactly E1 / E0 = (1 + pi_dom) / (1 + pi_for). Faster domestic inflation pushes E up, depreciating the currency.
Try this. Raise P_dom to 120 with P_for at 100: E_PPP climbs to 1.20, so domestic inflation depreciates the currency. Then move E_market above and below that 1.20 line to flip the verdict between under- and over-valued.
Discussion: PPP is a long-run anchor, not a day-to-day rule. Why can a currency stay over- or under-valued for years? Think about non-traded goods, trade costs, and persistent productivity gaps.

Why it matters

If a basket of goods costs far less in one country, buyers shift there until the currencies adjust. Persistent inflation gaps are the main long-run driver of where an exchange rate settles.

Formulas

Absolute purchasing power parity
E=P∗PE = \frac{P^{*}}{P}
EE is the value of the domestic currency (units of foreign currency per unit of domestic), PP the domestic price level, and P∗P^{*} the foreign price level. A higher domestic price level PP lowers EE, which is a depreciation.

Worked examples

Scenario

Country A runs 8% inflation while its trading partner runs 2%. What does PPP predict for A’s currency over time?

Solution

PPP predicts A’s currency depreciates by roughly the inflation gap, about 6% a year, so goods stay comparably priced across the two countries. PPP is a long-run tendency, not a day-to-day rule.

Common mistakes

  • ✗PPP holds at every moment. It is a long-run tendency, and exchange rates can deviate from it for years.
  • ✗PPP applies to every good. Many goods and services are never traded across borders, which is one reason real exchange rates drift from PPP.

Revision bullets

  • •Long-run exchange rates move toward purchasing power parity
  • •Higher relative inflation means a depreciating currency
  • •A long-run tendency, not a short-run rule

Quick check

Purchasing power parity predicts that a country with persistently higher inflation than its partners will see its currency

Connected topics

Fisher EquationMoney DemandFX Market

Sources

  1. Mishkin (2018), Ch. 18
    Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.
    The law of one price and purchasing power parity as the theory of long-run exchange rates.
How to cite this page
Dr. Phil's Quant Lab. (2026). Exchange Rates in the Long Run: Purchasing Power Parity. Derivatives Atlas. https://phucnguyenvan.com/concept/mb-exchange-rate-ppp
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