Theory of Purchasing Power Parity (PPP)
Also called the law of one price, the theory that the price of a currency (as defined by the exchange rate with another currency) is determined by the relative level of prices of the two countries. Basically the theory says that the price of a basket of goods should be the same in two countries. If 10 HC buys 15 FC then PPP says that the same basket of goods which cost 10HC should also cost 15FC. Essentially, the prices of currencies tend to move toward equilibrium.
The problem with the theory is that it does not accurately predict variations in exchange rates. PPP cannot be used along as a decision making tool with regard to forex transactions. PPP often does not take into account issues such as transportation costs, demand within the country, etc.
→ EXAMPLE:
Big Mac Index, see http://www.actionforex.com/financial-glossary/financial-glossary/big-mac-index-20041204335/
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