Purchasing power parity (ppp), Microeconomics

Purchasing Power Parity (PPP):

The exchange rate is determined by the relative purchasing power of currency withineach country.  For example, if a product X costs Rs. 100 in India and costs $2 in USA,then the rupee - dollar exchange rate is Rs. 50 per $.  This illustrates the theory ofPurchasing Power Parity (PPP) wherein two currencies are at purchasing power paritywhen a unit of domestic currency can buy the same basket of goods at home or abroad.There are two versions of PPP, the Absolute PPP and the Relative PPP.  The AbsolutePPP postulates that the equilibrium exchange rate between two currencies is equal tothe ratio of price levels in the two countries. Specifically, 

 R = P1/P2

Where P1 is the price level in the home country and P2 is the price level in the foreigncountry.The Relative PPP postulates that the change in exchange rate is equal to the differencein changes in the price levels in the two countries.  Specifically 

R' = p1'- p2'

Thus, the percentage change in exchange rate (R´) will be equal to the percentagechange in domestic prices (P´1) minus the percentage change in foreign prices (P´2).

This would be true as long as there are no changes in transportation costs, obstructionto trade (tariff and non-tariff barriers) and the ratio of traded to non-traded goods.Since trade and commodity arbitrage respond sluggishly (due to the above factors),relative PPP can be approximated in the long run.Thus, in the long run, the real exchange rate will return to its average level.  In otherwords, if real exchange rate is above long run average level, PPP implies that theexchange rate will fall. 

 

Posted Date: 11/10/2012 7:20:32 AM | Location : United States







Related Discussions:- Purchasing power parity (ppp), Assignment Help, Ask Question on Purchasing power parity (ppp), Get Answer, Expert's Help, Purchasing power parity (ppp) Discussions

Write discussion on Purchasing power parity (ppp)
Your posts are moderated
Related Questions
determination of optimal solution mathematical presentation

equilibrium output and prince is determined in williamson model of managerial discretion ?

We discussed why economists prefer to use available statistics and econometric techniques over other means of measuring consumer demand. Write a short essay describing a situation

What is Hicksian demand function? Hicksian Demand Function: The solution of expenditure function that is the function of (p, u) is denoted by h(p, u) and termed as the Hicks

Why narrowness of definition of a commodity may influence price elasticity of demand

What is the concept of the development? The concept of the development: Development is a complicated multi-dimensional concept to do along with enhancements in the human

What barriers to economic growth can be explained using the Harrod-Domar model? Definition and outline of the Harrod-Domar model; growth in national income = savings ratio over

ELASTICITIES OF SUPPLY AND DEMAND Usually, elasticity is a measure of the sensitivity of one variable to the other. It told us the percentage change in one variable in re

brife note on demand