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
draw a production possibility frontier task using the graph and value and identity the pareto efficent and inefficient point and the marginal oppotunity cost of x for each point of

Normal 0 false false false EN-IN X-NONE X-NONE MicrosoftInternetExplorer4

can average labor productivity fall even though total output is rising

Normal 0 false false false EN-IN X-NONE X-NONE MicrosoftInternetExplorer4

Mr. Smith can cause an accident, which entails a monetary loss of $1000 to Ms. Adams. The likelihood of the accident depends on the precaution decisions by both individuals. Spe

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

How to solve questions of endowments?

Jane receives utility from days spent travelling on vacation domestically(D) and days

Gains from International Trade: It leads to increased total world production of goods and services. International trade based on comparative cost advantage allows countries to

can you help me answer an economics question