Economics Exchange Rate Systems Questions Long
Purchasing power parity (PPP) is a theory in economics that suggests that the exchange rate between two currencies should be equal to the ratio of their respective price levels. In other words, PPP states that the exchange rate should adjust in such a way that a basket of goods and services should have the same cost in different countries when expressed in a common currency.
The concept of PPP is based on the law of one price, which states that in a competitive market, identical goods should have the same price in different countries when expressed in a common currency. If this were not the case, there would be an opportunity for arbitrage, where individuals could buy goods in one country and sell them in another to make a profit.
The implications of PPP for exchange rates are significant. If the exchange rate between two currencies deviates from their PPP value, it suggests that one currency is overvalued or undervalued relative to the other. If a currency is overvalued, it means that it can buy fewer goods and services compared to the other currency, making its exports more expensive and imports cheaper. Conversely, an undervalued currency means that it can buy more goods and services, making its exports cheaper and imports more expensive.
In the long run, PPP suggests that exchange rates will adjust to bring about equilibrium. If a country's currency is overvalued, its exports will become less competitive, leading to a decrease in demand for its currency and a depreciation in its exchange rate. On the other hand, an undervalued currency will make a country's exports more competitive, increasing demand for its currency and causing an appreciation in its exchange rate.
However, it is important to note that PPP is a theoretical concept and does not always hold in practice. There are several factors that can cause deviations from PPP, such as differences in trade barriers, transportation costs, taxes, and non-tradable goods. Additionally, PPP assumes that goods are identical across countries, which is not always the case due to variations in quality and preferences.
Despite these limitations, PPP provides a useful framework for understanding the relationship between exchange rates and relative price levels. It helps economists and policymakers analyze the competitiveness of a country's exports, predict future exchange rate movements, and assess the impact of exchange rate changes on trade balances.