However, this theory provides a benchmark for monitoring exchange rate movements. In the real world, the PPP is not always verified. This arbitrage (repeated over time by multiple subjects) implies the convergence of international prices of the goods considered. In short: if one unit of domestic currency could buy a larger amount of good x than it would be affordable within the national economy, then it would be profitable to buy x abroad and sell it inside, making profits on the difference between the prices.

The LOOP says that the same good sold in different countries should have the same price when expressed in common currency. The PPP is a generalization of the law of one price ( LOOP).

Purchasing power parity ( PPP) and the law of one price ( LOOP) In particular, Cassel studied the gold parities of the currencies of WWI participating countries with the specific purpose of estimating the equilibrium exchange rates (Colombo and Lossani, 2003).ġ. Although this idea has a history dating back at least to scholars at the University of Salamanca in the 15th and 16th centuries, the term purchasing power parity was first used by Gustav Cassel (1922, 1928), co-founder of the Swedish School of Economics together with Knut Wicksell and David Davidson.

It states that a basket of identical goods should have the same price, adjusted for exchange rate, across different countries. The purchasing power parity ( PPP) is a non-arbitrage condition.

Big mac index example with pesos