Equilibrium Relationships

Purchasing Power Parity (PPP) theory states that in the long run, the exchange rate between the currencies of two countries should be equal to the ratio of the countries’ price levels. PPP theory has a long history in economics, dating back several centuries, but the specific terminology was introduced in the years after World War I during the international policy debate concerning the appropriate level for nominal exchange rates among the major industrialized countries after the large-scale inflations during and after the war [69]. Since then, the idea of PPP has become embedded in how many international economists think about the world. For example, Dornbusch and Krugman [102] noted:

Under the skin of any international economist lies a deep-seated belief in some variant of the PPP theory of the exchange rate.

Rogoff [342] expressed much the same sentiment:

While few empirically literate economists take PPP seriously as a short-term proposition, most instinctively believe in some variant of purchasing power parity as an anchor for longrun real exchange rates.

Macroeconomic literature distinguishes between two notions of PPP: Absolute PPP and Relative PPP.