Absolute purchasing power parity is an economic concept that states that the purchasing power of citizens in different countries should be roughly the same. This means that the difference in prices for certain products in two countries can be directly traced back to the exchange rate for the currencies of those two countries. If a disparity exists, it means that the prices in one country are more favorable than in another, allowing buyers to benefit from that in a technique known as arbitrage. Another concept related to absolute purchasing power parity — known as APPP — is relative purchasing power parity, which takes inflation rates into consideration when comparing prices.
In a global economy, it is generally accepted that the economies of all the nations of the world are interconnected. As a result, though their currencies may have different values, the overall price for a product should be roughly the same no matter in what nation it is sold. This concept is known as the “law of one price,” and it is the basis for the notion of absolute purchasing power parity.
As an example of how absolute purchasing power parity works, imagine a hypothetical situation where one unit of currency from Country A is equal to two units of currency from Country B. A loaf of bread in Country A costs 20 units of that country’s currency. The law of one price stipulates that the loaf of bread in Country B should be 40 units, since the ratio of 40 to 20 would equal the exchange rate of two to one.
Using that example again, imagine that a loaf of bread in Country B was actually selling for a total of 35 units. This would mean that a consumer would be getting a better value by buying the bread in Country B. Assuming that many consumers would take advantage of this discrepancy, the sellers of bread in Country B would realize that they could sell the bread for more. This would raise the price for bread in Country B until absolute purchasing power parity is reached.
Inflation can also affect pricing in different countries, a fact that is accounted for by APPP’s counterpart, relative purchasing power parity. When considering the notion of purchasing power parity, certain factors may exist that can throw the prices off balance from what might be expected. For example, competition between sellers may be restricted in some nations. In addition, certain trade restrictions like tariffs can also affect APPP.