The idea originated with the School of Salamanca in the 16th century, and was developed in its modern form by Gustav Cassel in 1916, in The Present Situation of the Foreign Trade. The concept is based on the law of one price, where in the absence of transaction costs and official trade barriers, identical goods will have the same price in different markets when the prices are expressed in the same currency.
Another interpretation is that the difference in the rate of change in prices at home and abroad—the difference in the inflation rates—is equal to the percentage depreciation or appreciation of the exchange rate.
Deviations from parity imply differences in purchasing power of a "basket of goods" across countries, which means that for the purposes of many international comparisons, countries' GDPs or other national income statistics need to be "PPP-adjusted" and converted into common units. The best-known purchasing power adjustment is the Geary–Khamis dollar (the "international dollar"). The real exchange rate is then equal to the nominal exchange rate, adjusted for differences in price levels. If purchasing power parity held exactly, then the real exchange rate would always equal one. However, in practice the real exchange rates exhibit both short run and long run deviations from this value, for example due to reasons illuminated in the Balassa–Samuelson theorem.
There can be marked differences between purchasing power adjusted incomes and those converted via market exchange rates. For example, the World Bank's World Development Indicators 2005 estimated that in 2003, one Geary-Khamis dollar was equivalent to about 1.8 Chinese yuan by purchasing power parity—considerably different from the nominal exchange rate. This discrepancy has large implications; for instance, when converted via the nominal exchange rates GDP per capita in India is about US$1,965 while on a PPP basis it is about US$7,197. At the other extreme, for instance Denmark's nominal GDP per capita is around US$53,242, but its PPP figure is US$46,602, in line with other developed nations.