A dollar in New York buys a coffee. That same dollar, converted at the market exchange rate, might buy five coffees in Hanoi. This means that exchange rates don't fully capture the real difference in what money can buy across countries. Purchasing power parity tries to correct for this.
The Big Mac Index
The Economist invented a simple PPP tracker in 1986: the Big Mac Index. Since a McDonald's Big Mac is roughly the same product everywhere, its price in local currency (converted to dollars at market rates) reveals whether a currency is cheap or expensive relative to PPP.
Big Mac prices (approximate examples):
PPP for comparing economies
Market exchange rates can be distorted by capital flows, speculation, and trade policies. PPP-adjusted GDP is a better measure of real living standards. In PPP terms, China's economy is larger than the US economy (in nominal dollar terms, the US is still ahead). This is because Chinese workers, despite lower dollar salaries, have far more actual purchasing power within China than the raw dollar comparison suggests.
Why PPP isn't perfect
The "law of one price" that underpins PPP only holds for tradeable goods. Haircuts, restaurant meals, and housing can't be shipped between countries, so their prices can permanently differ. A Swiss haircut costs 5× a Vietnamese haircut not because the franc is overvalued but because local wages and costs are higher. PPP works better as a guide than a precise measurement.
What this means for you
PPP matters when investing internationally — a currency that looks expensive by market rates may be fairly priced by PPP. It also explains why outsourcing work to lower-cost countries is so effective: a software developer in India earning $15,000/year has similar purchasing power to a developer in the US earning $70,000/year. Understanding PPP changes how you interpret global economic comparisons reported in the news.