Purchasing Power Parity (PPP) is a theory which states that exchange rates between two currencies are in equilibrium when their purchasing power is the same in each of the two countries. In essence, the ration of the two countries’ price level for a particular good is the same as the exchange rate between the two countries. For example, McDonalds is a very popular fast food chain that is in countries worldwide. If a Big Mac in the United States costs $3.00, and that same Big Mac costs 2.15 Euros in Europe, then the exchange rate between the two countries can be determined to be .71667 Euros/$. The underlying basis for the Purchasing Power Parity is the “law of one price.” This means that for any one good, there is only one price – competitive markets will equalize the price of an identical good in two countries when the prices of this good are expressed in the same currency.  There are two versions of Purchasing Power Parity – absolute PPP and relative PPP. In the absolute PPP version, it is believed that all price levels should be equal worldwide for that one specific good if the price is expressed in one common currency. In the relative PPP version, it is believed that the exchange rate between any two countries will adjust to reflect the changes in the price levels of those two countries. Purchasing Power Parity is expressed by the following equation:             This equation implies that the exchange rate during that period should equal the inflation rate differential for that same period in a particular country. In the process of conversion, what Purchasing Power Parity does is eliminate the differences in price levels between countries. When using PPP, prices of goods cannot be compared with other years’ prices – because prices of goods rely on the inflation rate at the time the price is calculated, the only way to compare prices of goods from different years is to adjust the price to reflect the interim inflation rate for that particular period.