On the other hand, a US Dollar has more purchasing power than a Pakistani or Indian Rupee. These differences are usually because of availability and demand for the goods amongst other factors. By taking an international measure and determining the cost for that measure in each of the two currencies and comparing them we can solve this problem. (McGuigan, 2008)
This formula represents the exchange rate of one currency in relative terms to another currency. P1 is the price of an item in one currency while P2 is the price of the same item in another currency (Investopedia, 2008).
Although according to this theory, the relative prices for a same product should be equal in two different locations. However we rarely see this happen. This theory doesn't even hold true in areas inside a city. For example in a high end posh area of a city might sell the same product at a much higher rate than the shop set up in a low end area.
This brings us to the most popular example of purchasing power parity, the Big Max Index. Calculated by the Economist Magazine, the Big Mac index is used to find the exchange rate to determine the value of other items. Since McDonalds is virtually in every country, this index is readily applicable. ...Show more