PPP's major weakness

PPP's major weakness is that it assumes goods are easily tradable, with no costs to trade such as tariffs, quotas or taxes. Another weakness is that it applies only for goods and ignores services, where room for differences in value is significant.

Furthermore, there are several factors besides inflation and interest rate differentials impacting exchange rates, such as economic releases/reports, asset markets and political developments. There was little empirical evidence of the effectiveness of PPP prior to the 1990s. Thereafter, PPP was seen to have worked only in the long term (3-5 years) when prices eventually correct towards parity.2H4QGHXKBNUH

The prevailing market exchange rate

If the prevailing market exchange rate is $1.7 per British pound, then the pound is said to be undervalued and the dollar overvalued.

The theory then postulates that the two currencies will eventually move towards the 2:1 relation.

The PPP theory states

The PPP theory states that exchange rates are determined by the relative prices of similar baskets of goods.

Changes in inflation rates are expected to be offset by equal but opposite changes in the exchange rate. Take the classic example of hamburgers.

If the burger costs $2.00 in the US and £1.00 in the UK, then according to PPP, the £-$ exchange rate must be 2 dollars per one British pound.