Purchasing power parity

In economics, purchasing power parity (PPP) is a method used to calculate an alternative exchange rate between the currencies of two countries. The PPP measures how much a currency can buy in terms of an international measure (usually dollars), since goods and services have different prices in some countries than in others.

Explanation

Thus, per PPP Spot exchange rates between the US and UK should be

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: S = P$ / P£ ($/£)

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If the actual spot rate is > S, it would mean that the £ is over-valued and the $ is undervalued,

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If the actual spot rate is < S, it would mean that the $ is over-valued and the £ is undervalued

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Eg.

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:S (per PPP) = 1.5 $/£

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:S (Actual spot rate) = 1.8 $/£

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This would indicate that PPP suggests, 1 £ should buy you only 1.5 $.

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However in the actual market you can buy 1.8 $ (i.e. more $s) using 1 £

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Thus, the £ is over-valued(i.e. the £ is giving you more $s, than is suggested by the PPP) vs. the $, OR the $ is under-valued vs. the £

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