Purchasing power parity is an economic technique used when attempting to determine the relative values of two currencies. It is useful because often the amount of goods a currency can purchase within two nations varies drastically, based on availability of goods, demand for the goods, and a number of other, difficult to determine factors.

Purchasing power parity solves this problem by taking some international measure and determining the cost for that measure in each of the two currencies, then comparing that amount.

Perhaps the most famous example of purchasing power parity was given by the Economist Magazine as the Big Mac index. Using the Big Mac index, we determine the cost of a Big Mac in a number of countries and can then conclude an exchange rate based on this index. For example, if a Big Mac costs $3 in the US, and 9,000 riel in Cambodia, we can determine that the exchange rate is $1 for 3,000 riel. We would then use this indexed exchange rate to determine relative value of other items.

One of the primary uses of purchasing power parity is in lessening the misleading effects of shifts in a national currency. This is particularly an issue when calculating a nation's Gross Domestic Product. For example, if the riel falls in value to 80% of its value on the dollar, the GDP as expressed in US dollars will also drop to 80%. This does not accurately reflect the standard of living in that country (a common use of GDP), however, because the devaluation of the riel is most likely due to international trade issues that will not yet have had any effect on the average Cambodian. By using purchasing power parity, however, we are not misled by the temporary devaluation of the riel in relation to the dollar — a Big Mac still costs 9,000 riel in Cambodia and $3 in the US, and so our Big Mac index exchange rate remains the same.

Purchasing power parity is of course an imperfect device for determining things such as GDP, as the exchange rate will vary based on the basket item used for the index (in our case Big Macs). This effect is lessened by looking at a large sample of commodities, rather than one or two, but this simply minimizes the problem, it does not eliminate it entirely. It is also worth noting that purchasing power parity lumps items together into broad classes, not taking into account things such as quality; a hat is a hat is a hat, and its value in the index remains static, even though a shoddy hat's value on the international market would be much lower than a well made hat's value.