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PPP does not determine exchange rates in the short term as these are news-driven. Announcements about interest rate changes, changes in perception of the growth path of economies and the like are all factors that drive exchange rates in the short run. PPP, by comparison, describes the long run behaviour of exchange rates. The economic forces behind PPP will eventually equalise the purchasing power of currencies. This can take many years, however. A time horizon of 4-10 years would be typical.
The principle that, in the long run, currency exchange rates will adjust so that the cost of similar goods and services will tend to be the same in all markets and in all currencies. To preserve purchasing power parity, exchange rate movements will tend to reflect relative inflation rates. Unlike interest rate parity, which is enforced by financial arbitrage, purchasing power parity is an influence enforced, in the long run, by goods and services price arbitrage.
GDP vs PPP
It is worth explaining GDP versus Purchasing Power Parity and what the parity is in comparison to and how PPP is calculated. The difference between a Gross Domestic Product (GDP) computed the ‘standard’ way based on trade exchange, value of international currency (dollar), and the so-called Purchasing Power Parity value is probably best explained through an example, using hypothetical numbers.
If a pound of meat in the US costs $5 and in the UAE costs $20 (equivalent in dirhams), and if the Per Capita Income of a US citizen is $20,000 and that of an Emirati citizen is $20,000 (equivalent in dirham), then it is clear that the US citizen can buy more meat for the same amount of money. This gives a US citizen a higher standard of living (all other things being the equal). This is at the heart of how GDP is computed using Purchasing Power Parity or PPP.
The implication is that although an Emirati citizen may have the same per-capita income as the US, and therefore, the GDP of both countries will be the same if we assume both countries have the same population, then it becomes clear that although the Emirati GDP when computed in dollars amounts to 4 trillion dollars, in Purchasing Power Parity computation that number becomes 3 trillion dollars! That is, the Emiratis as a whole, can buy less products than US citizens as a whole.
So although both GDPs would be computed at $4 trillion each, the US GDP would be bigger than that of the UAE when computed using Purchasing Power Parity. So if you are a US citizen, that means, although you make the same amount of money as an Emirati citizen, you are likely experiencing a higher standard of living then your counterpart in the UAE who makes the same amount of money.
Now for poor countries, the opposite happens. That is, since a Yemeni citizen can rent a house for $10 dollars per month, as opposed to an Emirati citizen paying $500 per month, you can see (all other things being equal) that the Yemeni has a higher standard of living than what his income would lead an Emirati to believe, despite the fact that a Yemeni may earn 50 dollars per month. That is, the Yemeni in Yemen can buy more products for the same amount of money that an Emirati citizen can in the UAE. In fact, a lot more in some cases, as this example demonstrates. The result is that although Yemeni economy rated a GDP of (1 trillion dollars, lets say), the Purchasing Power of the economy as expressed by the Purchasing Power Parity computation may result in a 5 trillion dollar economy when compared to the UAE economy. This is a 5 times increase in the size of the Yemeni economy by simply changing how it is computed from straight dollar count to how much those dollars buy!
This is the basic idea behind Purchasing Power Parity computation of the GDP of an economy. It is worth adding that (as you probably have guessed by now) the resulting difference between the two ways of computing the GDP is dependent on how much open trade there is in a country, and dependent on how well the country is integrated in the world economy and its products’ competitiveness, as these things tend to equalise how much the same money can buy. That is why you will find less difference in western countries’ GDPs when computed the standard way, or the Purchasing Power Parity way.
Example
In a closed economy with no olive production you can control the price of olives, but in an open economy, the price of olives will be determined by the international market value, since if the price is too high, people will import cheaper olives, and if it is too low, people will export olives for profit, so that the price of olives comes into equilibrium with the international price. Now this assumes perfect market conditions, which never exist, and does not account for transport cost of the product (olives).
In addition, if a house in Yemen costs $10 per month and no one wants to live there because there is no demand for housing, for whatever reason, then that does not mean that the price of housing will go up (to reach equilibrium with the international market) since you cannot export that house.
Other issues to think about include how exchange rates affect GDP calculations. l