Purchasing power parity affects the international financial environment because under ideal conditions, the exchange rate between currencies of different countries equalize, in other words, the purchasing power is equal. The foundation of PPP is the “law of one price” (Antweiler, 2008). Three caveats exist with this law of one price: transportation costs, barriers to trade, and other transaction costs, can be significant; there must be competitive markets for the goods and services in both countries; and, it only applies to tradeable goods (Antweiler, 2008). There are two versions of PPP: absolute PPP which is the equalization of price across countries and relative PPP where change rates of price levels is equal to inflation rates (Antweiler, 2008). Specifically, relative PPP “states that the rate of appreciation of a currency is equal to the difference in inflation rates between the foreign and the home country” for example, if Canada’s inflation rate was 1% and the U.S. inflation rate was 3%, the USD would depreciate against the Canadian dollar by 2% annually (Antweiler, 2008).
Antweiler, W. (2008). Purchasing Power Parity. The University of British Columbia. Retrieved February 1, 2009 from http://fx.sauder.ubc.ca/PPP.html.