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Premium experiment • relative-price convergence

ECONOMICS • INTERNATIONAL ECONOMICS

Exchange Rates & Purchasing Power Parity

Compare a market exchange rate with a purchasing-power-parity benchmark while home and foreign prices evolve at different inflation rates.

● PPP CONVERGENCEspot rate ↔ relative prices
Spot rate
PPP benchmark
Misalignment
Inflation differential

Reasoning inspector

live model state
Spot exchange rate—
PPP benchmark—
Misalignment—
Home price basket—
Foreign price basket—
Inflation differential—

Experiment with the mechanism

Absolute purchasing power parity compares the same basket across countries after conversion into a common currency. Inflation differentials move the relative-price benchmark over time, while the market exchange rate may adjust only partially.

LEARN WITH THE SIMULATION

Understand Exchange Rates & Purchasing Power Parity by experimenting.

START HERE

Purchasing power parity compares the price of a common basket across countries after converting currencies. In the simulation the PPP benchmark is the home price basket divided by the foreign price basket, while the market exchange rate adjusts only partially toward that benchmark. Different inflation rates continually move the benchmark itself.

BUILD THE IDEA

What you should understand first

  • Compute an absolute PPP benchmark from relative price levels.
  • Distinguish a market exchange rate from a PPP-implied benchmark.
  • Explain how an inflation differential changes the relative-price benchmark over time.

TRY IT YOURSELF

What happens to the PPP benchmark when home inflation persistently exceeds foreign inflation?

  1. Record the starting market and PPP exchange rates.
  2. Set home inflation above foreign inflation.
  3. Play through the periods and watch both price baskets and the benchmark.
  4. Compare the final misalignment under slow and fast adjustment speeds.
Read the visual:

Faster home-price growth raises the home-to-foreign price ratio, so the PPP benchmark moves over time. Whether the spot rate remains close to that moving benchmark depends on the assumed adjustment speed.

WHY IT WORKS 01

Relative prices create a moving benchmark

Absolute PPP says that comparable baskets should have the same cost once converted into a common currency. If the home price basket rises faster than the foreign basket, the home-to-foreign price ratio rises. The exchange-rate benchmark therefore changes even if the currency market itself has not yet moved, which creates a temporary measured misalignment.

WHY IT WORKS 02

Why PPP can fail for long periods

Arbitrage is incomplete because many items in consumer price indexes cannot be cheaply traded across borders. Transport costs, taxes, product differences, local rents, services and market segmentation all weaken the law-of-one-price mechanism. Financial flows and expectations can also move currencies much faster than goods prices adjust, so PPP is better treated as a long-run benchmark than a mechanical short-run target.

DO NOT MIX THESE UP

Common misconception

PPP is not a reliable short-run exchange-rate forecasting rule. Goods are not identical across countries, many services are not traded internationally, transport costs and tariffs matter, capital flows dominate many currency movements, and measured price indexes differ in composition.

PRACTICE CHALLENGE

Can the spot rate move toward PPP while the measured misalignment still persists?

  • Create an initial gap between the spot rate and PPP benchmark.
  • Set different home and foreign inflation rates so the benchmark moves over time.
  • Use a moderate adjustment speed and play the path.
  • Explain why convergence toward a moving target need not eliminate the gap quickly.
Reveal the reasoning

Yes. The spot rate can be adjusting in the direction of the current PPP benchmark while inflation differentials simultaneously move that benchmark. Because both the target and the market rate change, the gap can persist or even widen temporarily despite partial adjustment toward PPP each period.

MODEL BOUNDARIES

What this simulation assumes

Every simulation simplifies reality or a mathematical system. These are the assumptions and limits to keep in mind while interpreting the results.

Model assumptions

  • The PPP benchmark equals the ratio of home to foreign price baskets.
  • Home and foreign inflation rates are constant during a run.
  • The market exchange rate adjusts a fixed fraction toward the current PPP benchmark each period.

Model limitations

  • Capital flows, interest rates, risk, trade barriers, nontraded goods and heterogeneous price indexes are omitted.
  • PPP is a long-run benchmark and the chosen adjustment rule is illustrative rather than empirical.

CONNECT IT

Where this matters

  • International economics
  • Real exchange-rate intuition
  • Inflation differentials
  • Currency valuation discussions

WORDS THAT MATTER

Key vocabulary

Spot exchange rate
The market currency-conversion rate represented in the simulation.
PPP benchmark
The exchange-rate ratio implied here by home and foreign price baskets.
Misalignment
The percentage gap between the spot rate and the PPP benchmark.
Inflation differential
Home inflation minus foreign inflation.