| Updated: September 12, 2025Purchasing power parity and interest rate parity theories
This lesson will cover the following
- Purchasing power parity theory – the Big Mac index
- Purchasing power parity index by the Organisation for Economic Co-operation and Development
- Interest rate parity theory
Purchasing power parity theory
The theory of Purchasing Power Parity postulates that foreign exchange rates should be evaluated by comparing the relative prices of a similar basket of goods between two nations. A change in a given country’s inflation rate should be offset by the opposite change in the country’s exchange rate. If prices in the country rise because of inflation, the country’s exchange rate should fall in order to return to parity.
The basket of goods and services is a sample of all goods and services covered by a country’s Gross Domestic Product. Consumer goods and services, government services, equipment goods and so on are all included in the basket. Among consumer goods and services are items such as food, drinks, clothing, footwear, tobacco, rents, medical goods and services, water and gas supply, fuel, transport services, recreational and cultural services, education services, etc.
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The Big Mac index
A popular example of purchasing power parity is the Big Mac index created by The Economist magazine. According to this approach, the exchange rate between two currencies should adjust so that a standard basket of goods and services costs the same in both currencies. The basket comprises a single Big Mac burger sold by the McDonald’s fast-food chain. The Big Mac PPP exchange rate between two countries is calculated by dividing the cost of a Big Mac in one country (in its own currency) by the cost of a Big Mac in the other (in its own currency). The resulting value is usually compared with the prevailing exchange rate. If the value is lower, the first currency appears undervalued relative to the second; if the value is higher, the first currency appears overvalued.
Let us have an example. In July 2008 a single Big Mac cost $3.57 in the United States and £2.29 in the United Kingdom. The implied purchasing power parity is calculated as follows: 3.57/2.29 = 1.56, or $1.56 to £1. The actual exchange rate (GBP/USD) back then was $2 to £1. Comparing both values we reach the following result: (2.00-1.56)/1.56*100 = 28.20%, or the GBP/USD exchange rate was overvalued by about 28%.
Purchasing power parity index by the Organisation for Economic Co-operation and Development (OECD)
The Organisation for Economic Co-operation and Development and Eurostat publish a more formal purchasing power parity index. The latest information on whether a particular currency is undervalued or overvalued against the US dollar is available on the OECD’s website (www.oecd.com). Data are shown in the form of a table containing price levels for major industrialised countries. Each column shows the number of monetary units needed in each country to purchase the same representative basket of consumer goods and services.
Limited application
The theory of purchasing power parity should be applied only for long-term fundamental analysis. Forces behind purchasing power parity will eventually equalise the purchasing power of currencies. This can occur within five to ten years.
A disadvantage of this theory is that it assumes goods can be traded without restriction and does not take into account tariffs on imports or taxes. Inflation, interest rate differentials, economic reports, trade flows and the political situation are factors that should also be taken into account when weighing the index of purchasing power parity.
Interest rate parity theory
This theory assumes that if two currencies have different interest rates, the exchange rate will include a discount or premium to prevent arbitrage opportunities. We discuss the role of arbitrageurs in the market in our forex trading guide.
A simple example is a situation where interest rates in the United Kingdom are, say, 2%, while interest rates in Japan are, say, 1%. Sterling would need to depreciate by 1% against the Japanese yen so that arbitrage opportunities can be avoided. The future exchange rate of GBP/JPY is reflected in the forward exchange rate known today. The forward exchange rate of the pound is at a discount, as it purchases fewer Japanese yen in the forward market than it does in the spot market. The forward exchange rate of the yen, on the other hand, is at a premium.
However, recent evidence casts doubt on the effectiveness of interest rate parity. Currencies of countries with high interest rates often increase in value because central banks are determined to cool an overheating economy by raising rates; this influence on currencies is not related to arbitrage.