The idea is that if we compare each country’s price of a Big Mac against the US dollar, and calculate the Big Mac index exchange rate, we can establish whether currencies are over or undervalued against the dollar. The Big Mac index takes PPP theory and narrows it down to a specific good: a McDonald’s hamburger. If there is a lasting disparity between the prices of a basket of identical goods across different countries, then it could create an opportunity for items to be bought in the country that sells it for the lowest price.
PPP theory suggests that, in the long run, the exchange rate between two currencies should move toward a point of conversion – so that the prices of identical goods and services become the same. PPP is used to determine how much the rate of exchange between two paper currencies impacts what consumers pay for daily goods and services. If we assume that PPP exists between these two nations, then a basket of goods that is worth $10 in the U.S. For example, suppose that the current exchange rate between Canada and the United States is 1.3 to 1, meaning that you’d need 1.30 Canadian dollars to buy one US dollar. It proposes that the price of a bundle of goods in one country should be equal to the price of that same bundle of goods in another country, once their currencies have been adjusted for the exchange rate. Purchasing power parity (PPP) is a theory of exchange-rate determination.
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