Final answer:
Purchasing Power Parity (PPP) is a theory that suggests exchange rates are in equilibrium when their purchasing power is the same in two countries. There are absolute and relative interpretations, leading to arbitrage or adjustments for inflation rate differences on foreign exchange rates.
Step-by-step explanation:
Purchasing Power Parity (PPP) is an economic theory that suggests exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. There are two interpretations of PPP: absolute and relative. Absolute purchasing power parity assumes that a basket of goods should cost the same in two different countries once prices are converted via the exchange rates. On the other hand, relative purchasing power parity considers the proportional difference in price levels between countries, implying that exchange rates will adjust to offset inflation rate differences.
Assuming the theory holds, under the absolute interpretation, if goods are cheaper in one country compared to another, businesses might engage in arbitrage by purchasing goods in the country where they are cheaper and selling them where they are more expensive. This would continue until prices equalize due to supply and demand for exchange rates. Under the relative interpretation, if one country's inflation rate is higher than another's, its currency should depreciate relative to the other currency to maintain purchasing power parity. This is crucial when comparing countries' economic indicators because it offers a more accurate measure of relative values, known as 'international dollars'.
Thus, the importance of PPP in comparing countries lies in its ability to provide a common ground for comparing economic output and living standards by adjusting for price level differences, using a common currency.