Purchasing power parity
The idea that exchange rates adjust to equalise what money buys in each country. The relative version has the exchange rate moving with the inflation differential; it holds loosely, and mainly over long horizons.
Where you will meet it
Purchasing power parity appears in 6 learning outcomes on the CFA syllabus. A few of them:
- Explain the international parity conditions, namely interest rate parity in its covered and uncovered forms, the international Fisher effect, purchasing power parity and forward rate parity
“Relative purchasing power parity says exchange rates move by the inflation differential.”
- Set out the main approaches used to forecast currency movements
“Purchasing power parity says exchange rates move to offset inflation differentials; it works poorly short term but anchors long-run fair value.”
- Contrast active currency approaches that rely on fundamentals-based valuation, technical analysis, carry trades or trading volatility
“Fundamental approaches estimate long-run fair value from purchasing power parity, real interest rate gaps, current account balances and risk premia, buying undervalued currencies and waiting for slow convergence.”
- Set out how the international parity conditions link to one another
“Ex ante relative PPP links the expected spot change to the expected inflation differential.”
Practise it
Practise purchasing power parity until it is automatic: questions that explain every wrong option.
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