Purchasing power parity is the ratio of two currencies based on the cost of similar goods in different countries.
It can be assumed that a certain standard set of goods in the United States costs $ 25, and in Russia 500 rubles. In this case, if we take the purchasing power parity as the basis, then it is fair to say that when we divide 500 by 25, we will get a rate of 20 rubles for 1 dollar. If quotes differ in one direction or another, traders have the opportunity to sell goods in another country, while receiving a certain profit. With a course, for example, of 30 rubles per dollar, you can earn 10 rubles on each unit of goods. The result of this should be one of two options: either comparing the prices of goods, or changing the exchange rate.
To implement this economic model in practice, a number of conditions must be met. To begin with, we are talking about the fact that the cost of moving goods from one country to another should be as low as possible: the absence of customs duties, the lowest possible cost of transportation, as well as many other parameters. Another prerequisite is the free conversion of currencies into each other, that is, there should be the ability to exchange them for each other in any amount, while there should be no currency control, state regulation or other obstacles. It can be said that ideal trading conditions are an extremely rare occurrence, therefore, it makes no sense to use purchasing power parity in practice, it serves only as a general guideline, that is, a direction for changing quotes in the future.
The hypothesis, which is based on the parity indicator, links the dynamics of the exchange rate with a change in the price ratio in the respective states. This whole theory is based on the fact that international trade makes it possible to smooth out the difference in the price movement of the main types of goods in world trade. The cost of such in different countries should be approximately the same, while it should be expressed in one specific currency. It is obvious that such a mechanism of price equalization may not work for all services and goods. With all this, the theory of purchasing power parity has empirical evidence. It works, turning out to be very useful in analyzing exchange rates and prices in countries where inflation is quite high. In conditions of hyperinflation, there is an almost complete coincidence of domestic prices with national currencies. It is important to understand that the correlation between the dynamics of exchange rates and the ratio of inflation rates in different countries exists in the long term.
The purchasing power parity and the theory based on it do not find enough evidence in the short term, especially in countries where the inflation rate is quite low. The weighted average price ratio, which is calculated on the basis of different commodity baskets in the two countries, for a number of years may not correspond to the level of the exchange rate, as well as its dynamics. However, the confirmation of this theory in the long term is sufficient to talk about such a factor affecting exchange rates, such as the country's trade balance, that is, the relationship of the trade balance and the dynamics of the exchange rate.
There is such a thing as currency parity. It is associated with the ratio between the two currencies, which is usually set in the manner prescribed by law. Previously, this indicator was based on the country's gold reserves, but now it is based on slightly different information.
If we talk about where these indicators are used, then we can say that they are very useful for calculating GDP at purchasing power parity. Thanks to him, one can more accurately compare the economies of two different countries.