Economics Exchange Rate Systems Questions Medium
Purchasing power parity (PPP) is a theory in economics that suggests that the exchange rate between two currencies should adjust in such a way that the purchasing power of each currency is equal. In other words, PPP states that the price of a basket of goods and services should be the same in different countries when measured in a common currency.
The concept of PPP is based on the idea that in an efficient market, the price of identical goods should be the same across different countries after accounting for exchange rates. This means that if the exchange rate between two currencies is not in line with their relative purchasing power, there will be an opportunity for arbitrage, where individuals can buy goods in one country and sell them in another to take advantage of the price difference.
PPP can be measured using various methods, such as the absolute PPP and the relative PPP. Absolute PPP compares the price levels of a basket of goods in different countries using a common currency, while relative PPP compares the changes in price levels over time.
The implications of PPP are significant for international trade and exchange rate policies. If PPP holds true, it suggests that exchange rates should adjust to reflect differences in inflation rates between countries. For example, if the inflation rate in one country is higher than in another, the currency of the country with higher inflation should depreciate to maintain purchasing power parity.
However, it is important to note that PPP is a theoretical concept and does not always hold in practice. Factors such as trade barriers, transportation costs, and non-tradable goods can affect the prices of goods and services in different countries, leading to deviations from PPP. Nonetheless, PPP remains a useful tool for understanding exchange rate movements and their impact on international trade.