Purchasing power parity (PPP) states that exchange rates between currencies are in equilibrium when their purchasing power is the same in the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When a country's domestic price level is increasing, that country's exchange rate must depreciate in order to return to PPP. The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency. PPP has been widely used by central bank for establishing new par value for their currencies when the old ones were in disequilibrium. It also used to forecast future exchange rates and determine in which countries to build plants. In its absolute version, PPP states that the price value should be equal worldwide expressed in a common currency. That means a unit of home currency should have the same purchasing power around the world. The relative version of PPP states that the exchange rate between the home currency and foreign currency will adjust to reflect changes in the price of the two countries. For example, if inflation is 10% in the U.S and 5% in China, then the dollar value of China yuan must rise by 5% to equalize the dollar price of goods in the two countries. In fact, according to PPP, exchange rate movement should cancel out changes in the foreign price level relative to domestic price level. The offsetting movements have no effects on the relative competitive positions of domestic firms and their foreign competitors. Thus, changes in the normal exchange rate is the actual exchange rate, have little significance in determine the true effects of currency changes on a firm or a nation. http://fx.sauder.ubc.ca/PPP.html