Currencies around the world differ in value, and understanding why they rise or fall is essential for students, traders, policymakers, and exam aspirants. Two important concepts used to compare currencies are:

• Purchasing Power Parity (PPP)
• Exchange Rate Parity

Both terms deal with how the value of one currency relates to another, but they do so from different perspectives. This article explains both concepts in simple language, highlights their differences, and provides examples to help learners grasp them easily.

What is Purchasing Power Parity (PPP)?

Purchasing Power Parity (PPP) is an economic theory that states:

“Two currencies are in equilibrium when a basket of goods costs the same in both countries after converting the currency.”

PPP compares currencies based on their purchasing power, not market fluctuations.

Key Idea of PPP

• If a product costs ₹500 in India and the same product costs $10 in the USA, then the PPP exchange rate is:
  ₹500 = $10 → 1 USD = ₹50 (PPP rate)

• If the actual market exchange rate is ₹85 per USD, it means:
  The rupee is undervalued, or
  The dollar is overvalued

Types of PPP

1. Absolute PPP: Same basket of goods should cost the same after exchange rate adjustment.
2. Relative PPP: Focuses on inflation differences between countries.

Famous Example: The Big Mac Index

The Economist uses the price of a McDonald’s Big Mac to compare PPP between countries.

PPP is widely used by:

• World Bank
• IMF
• Economists
• Government reports

PPP gives a realistic comparison of living standards and income across nations.

What is Exchange Rate Parity?

Exchange Rate Parity refers to the actual exchange rate determined by market forces, such as:

• Demand and supply of currencies
• Interest rates
• Inflation
• Trade flows
• Foreign investment
• Speculation

It reflects how much one currency is worth in the forex market right now.

Example: If 1 USD = ₹85 today, this is the exchange rate parity or nominal exchange rate.

Types of Exchange Rate Parity

1. Interest Rate Parity (IRP): Difference in interest rates between two countries determines forward exchange rates.
2. Covered Interest Parity (CIP)
3. Uncovered Interest Parity (UIP)

Factors influencing exchange rate parity

• RBI or central bank interventions
• Commodity prices (oil, gold)
• Global events
• Market speculation
• Capital flows

Unlike PPP, exchange rate parity fluctuates daily.

PPP vs Exchange Rate Parity: Key Differences

Here is a simple and clear comparison:

Simple Example to Understand Both

Let’s say:

• A product in India costs ₹600
• The same product in the USA costs $10
• PPP exchange rate = 600/10 = ₹60 per USD

But if the actual exchange rate is ₹85 per USD, this is the exchange rate parity.

So here:

• PPP says: Rupee should be ₹60
• Market says: Rupee is ₹85

This gap shows undervaluation or overvaluation.

Which One Is More Accurate?

• PPP gives long-term fairness between currencies.
• Exchange Rate Parity reflects real-time market conditions.

Both are useful but serve different purposes.