How can purchasing power parity be used to analyse exchange rates?

Purchasing power parity (PPP) can be used to analyse exchange rates by comparing the cost of a basket of goods in different countries.

Purchasing power parity is a theory that suggests that in the absence of transaction costs and barriers to trade, the exchange rate between two countries should adjust so that a basket of identical goods costs the same in both countries. This is often referred to as the 'law of one price'. If the price of the basket is not the same, it would imply that one currency is overvalued or undervalued relative to the other.

To analyse exchange rates using PPP, economists would first identify a basket of goods that is representative of consumption in both countries. This could include a range of items such as food, clothing, and household goods. The cost of this basket is then compared in each country using the current exchange rate. If the basket costs more in one country, it would suggest that the currency in that country is overvalued. Conversely, if the basket costs less, it would suggest that the currency is undervalued.

For example, if a basket of goods costs £100 in the UK and $130 in the US, the PPP exchange rate would be 1.3 dollars to the pound. If the actual exchange rate is 1.5 dollars to the pound, this would suggest that the pound is overvalued, as you would get more dollars for your pound than you would need to buy the same basket of goods in the US.

PPP is a useful tool for analysing exchange rates as it provides a simple way to compare the relative value of different currencies. However, it is important to note that it is a theoretical concept and in practice, there are many factors that can cause the actual exchange rate to deviate from the PPP exchange rate. These can include differences in taxation, transport costs, and trade barriers, as well as differences in consumer preferences and the availability of goods.