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Purchasing power parity

The purchasing power parity is the concept that two countries' exchange rates for currency equalize the difference in purchasing power between the two currencies.

Expanded Definition

Purchasing power parity (PPP) is a way to compare the value of currencies after factoring out swings in exchange rates that are caused by macroeconomic forces that haven't yet impacted the purchasing power of citizens. The Economist came up with the "Big Mac Index" as a way to explain PPP.

The goal is to figure out the exchange rate that makes it possible to buy a Big Mac in another country for the same price as it costs in the U.S. Let's use France as an example and $3.50 as the price of a Big Mac. I want to be able to convert that $3.50 into euros and buy a Big Mac with those euros.

Purchasing power parity takes a look at the exchange rated needed so that my $3.50 will buy a Big Mac in the U.S. or a Big Mac in France. It then compares this to the exchange rate of the currencies on the market and uses the difference as a way to judge whether the euro is undervalued or overvalued.

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