What theory predicts that exchange rates adjust so that identical goods cost the same in different countries?

Purchasing power parity is the theory that exchange rates adjust so identical goods cost the same in different countries.

PPP rests on the “law of one price”: after converting currencies, an identical tradable good should have the same price where markets are frictionless. If a laptop costs $1,000 in the United States and 4,000 rupees in India, PPP implies an exchange rate of 4 rupees per dollar for that product.

The theory is an ideal benchmark, not a rule that markets satisfy perfectly. Transport costs, tariffs, taxes, product differences, market power and goods that cannot be traded internationally—such as haircuts—create persistent price gaps. These limitations help explain why market exchange rates can differ substantially from rates calculated using a broad basket of goods.

A common mix-up is confusing PPP with the consumer price index. A CPI tracks price changes over time within an economy; PPP compares price levels across countries. Economists also distinguish absolute PPP, which predicts a level for the exchange rate, from relative PPP, which links exchange-rate changes to differences in inflation rates.