Purchasing power parity (PPP)

Purchasing power parity implies that the price level in two countries always will be equal, when the exchange rate has been taken into account. Purchasing power parity is explained in two different versions.

Purchasing power parity under the absolute version means that a product must have the same price in two different countries. According to the theory of purchasing power parity under the absolute version, we can determine the exchange rate if we know the price of goods in two different countries.

Absolute version
Exchange rate (GBP/USD) = price in England / price in USA

Purchasing power parity under the relative version implies that inflation in two different countries must be the same if the currency exchange rate should be unchanged. If the inflation is higher in one country, this country's currency will weaken against the other country's currency.

Relative version
Exchange rate change % = inflation Sweden % - inflation USA %