Economics Exchange Rates Questions Medium
Purchasing power parity (PPP) is an economic theory that states that the exchange rate between two currencies should be equal to the ratio of their respective price levels. In other words, PPP suggests that the exchange rate should adjust in such a way that a basket of goods and services should cost the same in different countries when converted into a common currency.
The concept of PPP is based on the idea that in an efficient market, the price of a particular good should be the same across different countries when expressed in a common currency. If the price of a basket of goods is lower in one country compared to another, then the currency of the country with lower prices is considered undervalued, and its exchange rate should appreciate to reflect the true value of the goods.
PPP is often used to compare the relative purchasing power of different currencies and to determine whether a currency is overvalued or undervalued. If a currency is overvalued, it means that it is stronger than its purchasing power suggests, and it may lead to a decrease in exports and an increase in imports, potentially causing a trade deficit. On the other hand, an undervalued currency may lead to an increase in exports and a decrease in imports, potentially resulting in a trade surplus.
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 actual exchange rates. Nonetheless, PPP provides a useful framework for understanding the relationship between exchange rates and the relative purchasing power of different currencies.