Purchasing Power Parity (PPP) is an economic theory that states the exchange rate between two currencies should equalize the purchasing power of the two currencies. In other words, PPP suggests that the same basket of goods and services should cost the same in different countries when the prices are converted to a common currency.
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PPP theory suggests that in the long run, exchange rates should adjust to equalize the purchasing power of different currencies.
PPP is based on the law of one price, which states that in the absence of trade barriers and transportation costs, identical goods should cost the same in different countries.
Deviations from PPP can occur due to factors such as trade barriers, transportation costs, and differences in productivity and inflation rates between countries.
PPP is used to compare the relative standard of living and purchasing power between countries, as well as to determine the appropriate exchange rate for a currency.
The Big Mac Index, developed by The Economist, is a popular example of a PPP-based comparison, using the price of a McDonald's Big Mac in different countries to gauge currency valuation.
Review Questions
Explain how the concept of purchasing power parity (PPP) relates to the demand and supply of foreign exchange markets.
The concept of PPP is closely tied to the demand and supply of foreign exchange markets. According to PPP theory, the exchange rate between two currencies should equalize the purchasing power of those currencies, meaning the same basket of goods and services should cost the same in different countries when converted to a common currency. Deviations from PPP can lead to arbitrage opportunities, where traders can profit by buying a currency in one market and selling it in another where it has greater purchasing power. This arbitrage activity helps drive exchange rates towards the PPP level, as increased demand for the undervalued currency pushes its price higher. Thus, the demand and supply of foreign exchange are influenced by the relative purchasing power of different currencies, as determined by PPP.
Describe how changes in inflation rates between countries can affect the exchange rate in relation to PPP.
According to PPP theory, if one country experiences higher inflation than another, its currency should depreciate relative to the other currency in order to maintain the same purchasing power. For example, if the inflation rate in Country A is higher than the inflation rate in Country B, the currency of Country A should depreciate against the currency of Country B over time. This is because the higher inflation in Country A erodes the purchasing power of its currency, requiring a lower exchange rate to equalize the cost of a common basket of goods between the two countries. Conversely, if inflation rates diverge, it can lead to deviations from PPP, creating opportunities for arbitrage until the exchange rate adjusts to restore the purchasing power equilibrium.
Evaluate the limitations and criticisms of using purchasing power parity (PPP) as a basis for determining the appropriate exchange rate between currencies.
While PPP provides a useful framework for understanding long-term exchange rate movements, it has several limitations in its practical application. First, PPP assumes the law of one price holds, but in reality, there are many factors that can cause price differences for the same good across countries, such as trade barriers, transportation costs, and differences in productivity. Second, PPP does not account for changes in consumer preferences, technological advancements, or the relative scarcity of certain goods, all of which can affect the composition of the consumption basket and distort the PPP calculation. Third, PPP is a long-term concept, and in the short-run, exchange rates can deviate significantly from PPP levels due to factors like capital flows, speculative trading, and monetary policy. As a result, PPP should be viewed as a general guideline for exchange rate determination rather than a precise, reliable predictor, especially in the short-term.