Essay on Purchasing Power Parity (PPP) and Exchange Rate Theory
A business studies essay on purchasing power parity, written as an MBA and undergraduate sample. It explains how exchange rates are set by supply, demand and expectations, what PPP claims, how the Big Mac index applies it with July 2026 prices, and six reasons the theory does not fit the observed data.
This is a business studies essay on purchasing power parity, written as a sample for an undergraduate international business or MBA economics module. It explains how exchange rates are determined, states what PPP claims, works one Big Mac index example through with July 2026 prices, and sets out the six standard criticisms. Referencing is Harvard, and the key texts are listed at the foot of the page.
More worked economics and strategy samples are in our business samples and MBA assignment samples, and our MBA assignment help page explains how we take on an economics or international business brief.
Three Theories of Exchange Rate Determination
Exchange rates matter both for international trade and for comparing one economy with another, and three theories compete to explain how they are set. The balance of payments approach treats the rate as the price that clears a country's external accounts. The monetary approach treats it as the relative price of two national monies, set by the supply of and demand for each. Purchasing power parity, the subject of this essay, explains the rate by relative price levels. The essay states the PPP proposition, applies it, and then tests it against the evidence.
How Are Exchange Rates Determined?
Exchange rates are set by the supply of and demand for a currency, unless a government or central bank intervenes. Demand comes from exports, direct and portfolio investment, and the expectation that the currency will appreciate. Supply comes from imports, domestic residents buying foreign assets, speculators selling a currency they expect to fall, and the central bank. Expectations move the rate faster than trade flows do.
Those expectations turn on interest rates, inflation, the outlook for the economy, political stability and demand for a haven currency. That is why an exchange rate behaves like an asset price rather than like the price of a good: the dollar against the euro today depends on where the market expects that rate to be in future, not only on what is being bought and sold now.
The effect on ordinary buyers is direct, which is what makes the idea easy to test against your own experience. If the dollar rises against the euro, a restaurant meal or a coat in Paris becomes cheaper for an American visitor without a single French price changing, because what the visitor pays is the local price converted at the market rate. Rates come in several forms: free-floating, pegged, spot and forward. A movement in any of them changes what an international business earns.
In the short and medium term, foreign exchange markets cannot be relied on to adjust to economic fundamentals. Reviewing the period, the Bank for International Settlements found that “three main factors underpinned exchange rate developments [in 2005 and 2006] … interest rate differentials … current account and net international liabilities of the United States … [and] continuing reserve accumulation in China …” (BIS, 2006, p. 79). Two of those three are stocks and flows of capital rather than prices of goods, which is the first clue that a theory built on price levels alone will struggle to explain what actually moves a currency.
What Is Purchasing Power Parity?
Purchasing power parity holds that the exchange rate between two currencies equals the ratio of their price levels. A fall in domestic purchasing power, meaning a rise in the domestic price level, should produce a proportional depreciation of the domestic currency. In other words, exchange rates should move in line with the inflation differential between the two countries, and should do so over the long run rather than week by week.
Absolute and relative purchasing power parity
| Point of comparison | Absolute PPP | Relative PPP |
|---|---|---|
| The claim | Absolute PPP The exchange rate equals the ratio of the two price levels | Relative PPP The exchange rate moves by the gap between the two inflation rates |
| What you need to test it | Absolute PPP The price of the same basket in both countries | Relative PPP The two inflation rates over the same period |
| A steady price gap from freight, duties or local costs | Absolute PPP Shows up as a lasting deviation | Relative PPP Cancels out, because only changes are compared |
| Worked example in this essay | Absolute PPP Big Mac, July 2026: £5.49 ÷ $6.22 = £0.883 per dollar, against £0.742 at market | Relative PPP Illustrative: prices up 5% in Britain and 2% in the United States, so the pound loses about 3% against the dollar |
That definition holds the two versions of the theory that textbooks separate. Absolute PPP is the statement in levels: divide the price of a basket in one country by its price in the other, and the result should be the exchange rate. Relative PPP is the statement in changes: over a period, the exchange rate should move by the gap between the two inflation rates. With illustrative figures, if prices rise 5% in Britain and 2% in the United States over a year, relative PPP predicts that the pound loses about 3% against the dollar. Relative PPP can hold when absolute PPP fails. Freight, insurance and duties keep the same goods dearer in one country than another, and a gap that stays the same size breaks absolute PPP but cancels out when only changes are compared.
Interest rates are one reason both versions are long-run claims. Investors move money to where rates are high, which lifts the currencies of high-rate countries. If those rates are high because inflation is high, the currency rises at the moment PPP says it should fall. Prices adjust over months and years; capital can move in a day.
PPP is not only a theory. It is also the basis on which international institutions compare national income across countries: the World Bank's International Comparison Program collects prices worldwide and publishes the PPP conversion factors used to compare GDP between economies, drawing on the parallel price programmes run by Eurostat and the OECD. When a report says an economy is the third largest "at PPP", this is the calculation behind it.
You may also like reading Business Research Methods – Sample Research Proposal for MBA and our University of Hertfordshire Global Economy essay on inflation, which covers the inflation side of the same argument.
What Is the Big Mac Index?
The Big Mac index is The Economist's test of absolute PPP with a single product, published since 1986. Divide the local price of a Big Mac by the American price to get the exchange rate at which the burger costs the same in both countries. The gap between that rate and the market rate is the currency's over- or undervaluation.
Price of a Big Mac in US dollars at market exchange rates, July 2026
Chart data
| Item | Value (USD) |
|---|---|
| Britain | 7.4 USD |
| Euro area | 7.08 USD |
| United States | 6.22 USD |
| Australia | 5.95 USD |
| Canada | 5.81 USD |
| Pakistan | 3.89 USD |
| South Africa | 3.49 USD |
| Philippines | 2.74 USD |
| India | 2.45 USD |
Take the July 2026 release of the index data (The Economist, 2026). A Big Mac cost £5.49 in Britain and $6.22 in the United States, so the burger-parity rate was 5.49 ÷ 6.22 = £0.883 per dollar. On the survey date a dollar bought only £0.742 in the market, fewer pounds than parity implies, so the pound was dearer than the burger says it should be: overvalued by 0.883 ÷ 0.742 − 1 = 0.190, or 19.0%. The same answer comes from the other direction. At the market rate the British Big Mac cost $7.40, which is 19.0% more than the American one.
Run for India, the same arithmetic gives the opposite sign. The burger cost ₹236.25, which implies ₹38.0 to the dollar against a market rate of ₹96.26, so by the Big Mac standard the rupee was 60.5% undervalued. At the market rate an Indian Big Mac cost $2.45.
The appeal is that the product is standardised: a burger made to the same specification in dozens of countries is closer to a genuinely identical good than most items in a price index. The weakness is that a burger is largely a non-traded good. Its price includes local rent, wages, taxes and the cost of local ingredients, none of which can be arbitraged across a border, so the gap the index reveals is partly a gap in labour costs and property prices rather than in currency value. An undervaluation as large as India's therefore says something about Indian wages and rent, not only about the rupee. The index is a teaching device that makes the PPP idea concrete, not a forecasting tool.
Does PPP Explain Actual Exchange Rates?
Not well in the short run. Krugman and Obstfeld (2006, p. 379) put it bluntly: “all versions of the PPP theory do badly in explaining the facts. In particular, changes in national price levels often tell us little about exchange rate movements.” PPP works better as a long-run anchor than as a prediction of next quarter's rate.
Six criticisms account for most of that failure, and an essay is marked on separating them rather than listing them.
- The assumed functional link. PPP assumes a direct relationship between the purchasing power of the two currencies. In practice the relationship is mediated by the balance of payments position, tariff structures and capital flows.
- Non-comparable index numbers. The price indices used to construct PPP differ between countries in base period, in the basket of commodities and in weighting, so the ratio compares two things that were not measured the same way.
- The balance of payments is ignored. The theory takes no account of whether the external accounts are in equilibrium, and they usually are not.
- Free trade is assumed. PPP presumes unrestricted international trade and no intervention. Tariffs, quotas, transport costs and managed exchange rates all break the arbitrage the theory depends on.
- Structural change is excluded. Economic relations between countries change, through productivity growth, trade agreements and shifts in what a country produces, and the theory has no way to absorb that.
- It holds only for purely monetary changes. PPP is a long-run proposition that applies when the disturbance is monetary. Where the change is real, the theory is being asked a question it was not built to answer.
The verdict is therefore mixed rather than negative. The theory still explains some notable features of exchange rate behaviour. Where the inflation rates of two countries diverge, relative PPP expects the market rate to move just far enough to leave the real exchange rate, the rate adjusted for prices, unchanged. The difficulty is that the equilibrium rate itself depends on the macroeconomic model used to define it, which is why a point prediction is unreliable even when the direction is right. The honest conclusion for an essay is that PPP is a tool for comparing economies and for thinking about the long run, not a method for forecasting a currency.
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Sources
Cited in this essay
- Krugman, P. and Obstfeld, M. (2006) International Economics: Theory and Policy. 7th ed. Boston, MA: Addison-Wesley. The edition the quotation at p. 379 is taken from.
- Bank for International Settlements (2006) 76th Annual Report. Basel: BIS, p. 79. bis.org. Source of the quotation on 2005 to 2006 exchange rate developments.
- The Economist (2026) The Big Mac index. The index has run since 1986. economist.com.
- The Economist (2026) big-mac-data, July 2026 release, file big-mac-raw-index.csv. github.com/TheEconomist/big-mac-data. Data licensed CC BY 4.0. Source of the British, American and Indian prices and exchange rates in the worked example and of the dollar prices in the chart.
- World Bank, PPP conversion factor, GDP (LCU per international $). data.worldbank.org. Produced by the International Comparison Program with the Eurostat and OECD purchasing power parity programmes.
- World Bank, International Comparison Program. worldbank.org. The price survey behind the published PPP conversion factors.
Further reading, not cited above
- Krugman, P., Obstfeld, M. and Melitz, M. (2012) International Economics. 9th ed. Pearson Education Asia. The later edition of the same textbook, for the chapter on price levels and the exchange rate in the long run.
- Blanchard, O. (2009) Macroeconomics. 5th ed. Pearson Education. For the open-economy chapters on interest parity and the monetary approach named in the opening section.
- Hill, C. and Hult, G. (2018) Global Business Today. 10th ed. McGraw-Hill. Chapter 10, The Foreign Exchange Market, and Chapter 11, The International Monetary System.
Frequently Asked Questions
What is purchasing power parity in simple terms?
Purchasing power parity says that, in the long run, the exchange rate between two currencies should move to the level at which the same basket of goods costs the same in both countries. If prices rise faster in one country, its currency should fall by roughly the same amount.
What is the Big Mac index?
It is a light-hearted currency guide that The Economist has published since 1986. Because a Big Mac is made to the same specification in dozens of countries, its price stands in for a whole basket of goods. Where the burger costs more in dollars than it does in the United States, the index calls that currency overvalued; where it costs less, undervalued.
Why does purchasing power parity not hold in the short run?
Because exchange rates respond to interest rates, capital flows and expectations far faster than prices adjust. Transport costs, tariffs, taxes and non-traded services also stop identical goods costing the same across borders. PPP is a long-run anchor, not a short-run predictor.
What are the main criticisms of PPP theory?
Six recur in the literature: it assumes a direct functional link between the two currencies' purchasing power; price index numbers are not comparable across countries; it ignores the balance of payments; it assumes free trade and no intervention; it cannot absorb structural change; and it holds only when the changes are purely monetary.
How do I structure a purchasing power parity essay?
Define the exchange rate and say how it is determined, state the PPP proposition precisely, give one applied example such as the Big Mac index, then test the theory against evidence and set out the criticisms. Finish by saying what PPP is useful for rather than whether it is right. That is the order this sample follows.
