Purchasing power parity (ppp), Microeconomics

Assignment Help:

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. 

 


Related Discussions:- Purchasing power parity (ppp)

Compensared demand function, What are the properties of compensared demand ...

What are the properties of compensared demand function

Equilibrium level of economic output, Provide an economic explanation of wh...

Provide an economic explanation of what you have shown in your diagram above.  Iceland was a small open economy with perfect capital mobility. Consequently, the equilibrium domesti

Oligopoly, what are the factors causing oligopoly market?

what are the factors causing oligopoly market?

Snob effect - network externalities, The Snob Effect - If network is n...

The Snob Effect - If network is negative externality, a snob effect exists. * The snob effect refers to desire to own unique or exclusive goods. * The quantity demanded o

Explain about Growth and development of country, How might one assess if a ...

How might one assess if a country in experiencing both growth and development? This is a matter of explaining clearly both growth and development; growth is an enhance in GDP (

Elasticity, what are the uses of elasticity to the private sector

what are the uses of elasticity to the private sector

Compute marginal cost and average total cost, Crumble Corporation produces ...

Crumble Corporation produces cookies. Here is the relationship between the number of workers and output (in dozens of cookies) in a given day: Workers Output Marginal Product T

Reducing risk, Reducing Risk Three methods consumers attempt to reduce ...

Reducing Risk Three methods consumers attempt to reduce the risk are:  1) Diversification  2) Insurance  3) Collecting more information

Product transformation curve, Production: - Firms should choose how muc...

Production: - Firms should choose how much of each to produce. - The alternative quantities can be illustrated by using product transformation curves. Product Transforma

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd