What is a method for adjusting exchange rates so two currencies have equivalent purchasing power?

The method for adjusting exchange rates so that two currencies have equivalent purchasing power is known as purchasing power parity (PPP). This economic theory proposes that in the long run, exchange rates should move toward the rate that would equalize the prices of an identical basket of goods and services in different countries.

The core idea behind PPP is that, if markets are efficient, the price of the same good should be the same when expressed in a common currency, regardless of where it is sold. For instance, if a pair of shoes costs $50 in the United States and £30 in the United Kingdom, the exchange rate should adjust to maintain this price equivalence.

Purchasing power parity is frequently used in economic analysis and international comparisons to assess whether currencies are undervalued or overvalued based on the cost of goods. This concept helps in understanding the true value of currencies beyond just their nominal exchange rates, leading to better-informed financial decisions in international trade and investment.