The basic concept of Purchasing Power Parity theory or PPP, revolves around the purchasing power of a dollar. Economists often use the PPP theory to compare the cost of living from one country to another. This theory breaks down into the three main concepts of absolute parity, relative parity and interest rate parity.
Absolute PPP theory states that once a consumer exchanges a domestic currency for a foreign currency, the purchasing power of the domestic and foreign currencies is equal. Absolute PPP only refers to situations in which consumer purchases the exact same basket of goods in both the foreign and domestic markets. For example, a bushel of apples costs you $1 in the United States. According to absolute PPP, a bushel of apples will cost you $1 in a foreign country after you convert your U.S. dollar to the currency of that country.
Relative PPP states there is a correlation between price-level changes between two countries and currency exchange rates. Relative PPPP maintains that though the price for the same item varies in different countries, the percentage of the difference is relatively the same over a longer period. The percentage of appreciation or depreciation of currencies is equal to the percentage difference between the two country’s inflation rates. For example, if the inflation rate in the U.S. is 4 percent and the inflation rate in Japan is 7 percent, then the depreciation rate of the Japanese Yen compared to the U.S. dollar is 3 percent.
Forward rates are when investors specify a currency exchange rate in the present for a contract they plan to execute at a future date. The spot rate is the present exchange rate between currencies. Interest rate PPP states that the percentage difference between forward and spot rates is equal to the difference in percentage of the two countries interest rates. For example, if the interest rate in the U.S. is 5 percent and the interest rate in Japan is 8 percent, then the percentage between the forward and spot rates is 3 percent. Meaning the value of the Japanese Yen will depreciate against the U.S. dollar at a rate of about 3 percent over time.