Magoosh GRE

Purchasing power parity, theory of exchange rate determination.

| December 21, 2012

INTRODUCTION:

The objective of this paper is to better understand one of the key concepts of real exchange rate determination and building blocks of macroeconomic model, ppp. The main reason to focus on this topic is due to the fact that most of the large companies are working beyond the national boundaries and are trying to expand their business at international levels, so it becomes vital for managers and investors while making international investment decisions to gauge the impact of fluctuation of consumer goods prices, tradable and non-tradable goods could have on the profitability of their businesses.Although the term “purchasing power parity” was coined as recently as 80 years ago (Cassel, 1918), it has much longer history in economics[1].PPP is generally attributed to Gustav Cassel’s writings in the 1920s, although its intellectual origins date back to the writings of the nineteenth-century British economist “David Ricardo”. Probably, it is the oldest theory of exchange rate determination.

In section 1 of this paper, I will define the concept of ppp, discuss the theory behind it, and elaborate its practical implications in real world development. The section 2 will clarifies the nuances between absolute ppp and relative ppp and tests of the validity of the ppp theory over the time period. The section 3 elaborates Why is more preferable to say that ppp holds in the long run than in the short run. The section 4 explains why ppp does not hold in the short run, what are the economic factors lies behind it in deviating ppp from actual exchange rate.    It distinguishes between those factors which would prevent absolute ppp from holding, but would not necessarily prevent relative ppp from holding, and those which clearly prevent relative ppp too. It also explains those factors which would lead to ppp failing in the long run. In section 5, there are concluding remarks.

SECTION 1: UNDERSTANDING PURCHASING POWER PARITY

In thissection, I will define purchasing power parity by using the examples to elaborate how it works in the real world and discuss it how it relates to real exchange rates.

WHAT IS PPP?

The purchasing power parity exchange rate is the exchange rate between two currencies’ that would equate the two relevant national price levels if expressed in common currency at that rate, so that ppp of a unit of one currency would be the same in both countries.The basic concept underlying ppp theory is that arbitrage forces will lead to the equalization of goods prices internationally, once the prices of goods are measured in same currency. As such theory represents an application of the ‘law of one price’[2].

LAW OF ONE PRICE:

The fundamental idea behind this theory is the law of one price.LOP[3] refers to identical products which are sold in different markets will sell in the same prices when expressed in terms of a common currency in the presence of competitive market structure and absence of transportation costs and other barriers to trade. Thus, it provides a framework to relate currency in one market (the domestic market) to currency in another market (foreign market).In algebraic form, LOP posits that for any good I: p

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