What economic measure compares inflation rates between two countries to determine currency valuation?

Purchasing Power Parity (PPP) is a key concept used to compare the relative value of currencies based on the price levels in different countries. The underlying principle of PPP is that in the absence of transportation costs and barriers to trade, identical goods should have the same price when expressed in a common currency. When analyzing inflation rates between two countries, PPP helps determine how much the currency of one country should be worth in terms of another, based on the cost of living and inflation in both countries.

For instance, if one country experiences higher inflation than another, the purchasing power of its currency would decline relative to the other country’s currency. Thus, PPP provides a method to assess currency valuation by accounting for these inflation differentials. This approach is particularly useful for economists and investors who seek to understand how currency values should adjust based on fundamental economic conditions, making it a critical measure in international finance and economic analysis.