Purchasing Power Parity

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Purchasing Power Parity relies on the assumption that a unit of currency (let's say $) has the same purchasing power in every market even after taking into account various barriers or special costs for countries. This depends on valuation; i.e. the relationship between market price and underlying value. If a currency is overvalued, then the currency purchases less than the ER implies (PP<ER), and vice versa. In most developing countries, PP>ER since their currencies tend to be undervalued.

The basket used to determine the PPP could be anything, and The Economist uses Big Macs. A recent article on the Big Mac index in the latest issue of The Economist can be found here: http://www.economist.com/node/17257797?story_id=17257797&fsrc=rss It speculates that the Yuan is massively undervalued against the dollar, in the wake of a threat of a currency war.