PPP Meaning and Theory Explained to Beginners

Before we identify the PPP meaning, we need to figure out what is PPP. The abbreviation stands for purchasing power parity. It is a popular economic theory that makes it possible to evaluate and compare the economic health of two separate countries. In other words, the theory comes as a tool to perform in-depth economic analysis based on specific insights and financial data. The PPP theory in economics can be of different types depending on the way it is applied to the financial market.

In this article, we will define what PPP means as well as how to use the theory of purchasing power parity when trading different assets.

Purchasing Power Parity Theory Definition

The main philosophy of the PPP theory relies on the idea of all the countries using the same currency. In this case, PPP calculations will make it possible to clarify how much different things would cost in different regions. As a result, the theory lets traders calculate the rate of the currency exchange that identifies the purchasing power of another currency.

Besides, the original version of the purchasing power parity theory considered all services and products in all countries required equalizing. The concept is still used today although in quite different forms depending on the way you want to apply the theory.

Note: while international trade is developing rapidly, consumers have a chance to look for the best price when shopping globally. They get enough time and tools to compare different shopping options which eventually leads to everyone having equal purchasing power or “parity”.

How Does PPP Theory Work?

Why would one ever need to use the PPP theory? Well, that depends on specialization. Economists would rather apply it to compare and contrast:

1. The economic output of different countries.
2. Identify the most powerful and largest economy across the globe.
3. Get a complete picture of some nations’ economic health.

Additionally, the rate can make great use for shares and bondholders or investors, as they will be able to predict fluctuation. Besides, this will work for currency traders whenever they need to indicate the weakness of the particular currency.

Concepts of PPP in Economics

Experts generally divide the theory into two different concepts:

• Absolute Purchasing Power Parity (APPP) – it is the basic concept of the PPP theory that shows two baskets of goods of the same value after the two currencies have been exchanged. When following this particular concept, specialists generally convert global currencies into USD.
• Relative Purchasing Power Parity (RPPP) – it comes as an extended version of the previous concept. The key difference is that RPPP considers the same production values to equal out from time to time. In other words, the concept suggests a correlation between currency exchange rates and inflation.

Ways to Apply the Theory of Purchasing Power Parity

In general, PPP refers to a group of macroeconomic rates that make it possible to measure and compare living standards along with the economic productivity of different nations. This is why it is commonly adjusted to GDP.

At the same time, traders and investors can benefit from many other ways to use the theory as the instrument to process different types of socioeconomic data. For example, traders may use it to predict financial market movements. Economists will have a chance to measure the level of global poverty and some other parameters.

PPP Theory in Forex

As a trader, you may need the PPP theory to proceed with long-term currency pair evaluations and forecasts. For example, the PPP rate will help you identify the potential currency pair direction letting you decide on whether to buy or sell the asset.

On the other hand, traders should never rely only on PPP. Your trading strategy must not be limited to purchasing power parity theory. It represents only an idea of equal prices and does not guarantee precise evaluation. This is where you may need extra tools in the form of market insights and fundamental analysis.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.