Purchasing power parity and exchange rates are inextricably linked together by the so-called law of one price, which states that goods should essentially cost the same no matter where they are purchased. This is the driving concept behind purchasing power parity, or PPP, which shows the relationship between countries in terms of their purchasing power. When a certain product costs more in one country than it does in another, PPP implies that the disparity should be equal to the difference in exchange rates between the currencies of the two countries. Should that not be the case, it represents a buying opportunity for consumers, which will eventually drive prices back toward the equilibrium of purchasing power parity.
For countries that have different currencies, exchange rates are established for the differences in values between those currencies. According to the law of one price, however, products should essentially cost the same everywhere and countries should have equal purchasing power. This contradiction is explained by the relationship between purchasing power parity and exchange rates.
As an example of how the concepts of purchasing power parity and exchange rates work, imagine that four units of currency in Country A equal one unit of currency in Country B, meaning that the countries have an exchange rate of four-to-one. In country B, a certain product costs 25 units of currency. According to PPP, that product should cost 100 units of currency in Country A. This is because the ratio of four-to-one is equal to the ratio of 100-to-25.
Using this same example, imagine that the product is priced at only 95 units of currency in Country A. This means that consumers would get a value by shopping in Country A. It also means that, according to the laws of economics, the demand for the product in Country A will grow, causing manufacturers of the product in that country to ramp up production. Since more production means higher costs, the firms in charge of production will raise the product's price, until it eventually reaches the equilibrium implied by PPP.
In this way, purchasing power parity and exchange rates essentially work in tandem. It is important to note that these concepts will only work in harmony if the countries in question have competitive markets. If a government controls economic forces in a country, or if there is a monopoly by a single firm over production of certain goods, purchasing power parity is likely to be thrown askew when compared to exchange rates.
