Purchasing power parity

A theory of the exchange rate, stated in two strengths. The absolute form says the rate equals the ratio of the two countries' price levels, so the same basket costs the same amount everywhere once converted. The relative form, which is the version economists actually work with, says the change in the rate over a period equals the difference between the two countries' inflation rates over that period. The mechanism proposed underneath both is arbitrage in goods: where the same thing is cheaper in one country, trade flows towards it until the rate adjusts.

Estimating it means comparing price levels, which is harder than it sounds, since a basket that represents spending in one country rarely represents it in another. International institutions publish conversion factors for exactly this purpose, and comparing economies by their output converted at those factors rather than at market rates is the measure's least contested use. The informal single item comparisons that circulate in the press, priced off one standardised restaurant product, are teaching devices rather than estimates.

What it is not is a short horizon forecast. Deviations from parity have historically persisted for years, with the empirical literature putting the time for half of a deviation to close in years rather than months, a result stable enough to be discussed as a puzzle in its own right. Non traded goods and services, transport, tariffs, quality differences and capital flows that dwarf trade flows all break the arbitrage. The disagreement is not about whether deviations persist, which is settled, but about whether parity anchors the rate over the long run at all, and estimates move substantially with the sample period and the method chosen.