As a result, the exchange rate must move towards a long-term symmetry value that confirms this is true. PPP or the law of price should hold if:
There are no barriers to trade or arbitrage in the good
There are no transaction costs
The good being traded is perfectly homogeneous
Let’s consider an example:
Say, the price of exactly the same sports car in the Czech Republic and Germany is CZK1 million and EUR100,000. If we use this sports car as broadly representative of the price differential between these two countries, then we derive from this that the PPP equilibrium value of the Euro–Czech koruna exchange rate should in turn be 10 (i.e. 1,000,000/100,000).
If the PPP equilibrium value of the Euro–Czech koruna exchange rate is 10, then:
1. The actual exchange rate should relapse towards this over time.
2. The actual exchange rate reflects a calculable degree of over, or undervaluation relative to that PPP value.
Let’s say that now the actual Euro–Czech koruna exchange rate is around 21.70. When calculating PPP value, it shows that the Czech koruna is expressively undervalued relative to PPP and should escalate over time to remove that undervaluation.
In the world where there are no barriers to trade or find information, a German car buyer will be fully aware that the same car is cheaper in the Czech Republic. Hence, if there are no laws against such practice, he or she will travel there, buy the car and drive back.
The above example shows the principle of PPP concept. The transmission mechanism presented above would cause an eventual removal of that Czech koruna undervaluation in the following manner:
Cheap currency ? Attracts buyers ? Increased demand to buy goods ? Currency appreciates
In order to understand PPP better, below are couple of mathematical definitions to consider:
D = V × P
V = The PPP long-term equilibrium exchange rate value
D = Domestic price level of goods
P = Foreign price level of goods
This reflects the fundamental view of PPP, which is that the long-term equilibrium value of an
exchange rate is a direct ratio between the “internal” prices of the same tradable goods between two countries.
Forex traders however, think of exchange rates with regard to the base and the term currencies, using the base currency first.
Thus, the exchange rate between the US and Euro is not seen as euro per dollar, but expressed instead as dollar–yen. This is how foreign exchange traders. Therefore, PPP formula can be expressed in a slightly different manner:
D = PT
E = The PPP long-term equilibrium exchange rate value
PT = Price level in the term currency
PB = Price level in the base currency
Returning briefly to our sports car example, this is indeed how we derived the supposed PPP
value of the Euro–Czech koruna exchange rate using the price levels given.