Which theory says exchange rates should equalize the price of identical goods?

Purchasing power parity says exchange rates should equalize the price of identical goods. In its simplest form, the theory proposes that a comparable basket should cost the same in two countries once prices are converted into a common currency.

PPP rests on the law of one price: if identical, tradable goods have different prices after conversion, buyers and sellers should have an incentive to trade until the gap narrows. For example, if a computer costs 500 U.S. dollars in one market and 2,000 Hong Kong dollars in another, the implied parity rate is 4 Hong Kong dollars per dollar.

Absolute PPP compares price levels, while relative PPP focuses on how inflation differences should influence exchange-rate changes over time. Economists use PPP-adjusted figures to compare GDP, income, and living standards because market exchange rates can be heavily affected by financial flows and speculation.

Actual exchange rates rarely match PPP exactly. Transport costs, tariffs, taxes, wages, product-quality differences, non-traded services, and different national consumption baskets all create gaps. The Big Mac Index is a famous informal PPP demonstration, but a serious international comparison uses much larger baskets assembled by organizations such as the OECD and World Bank.