Question

1. a. Explain what PPP is, what it assumes, why these assumptions mean it may not hold in the real world, and when it tends to hold and why. Discuss crucial reasons it will tend to break down. b. Explain what the Real Exchange Rate is, and how it is different from PPP. What is the implication for the Real Exchange Rate if PPP holds? Explain why.

Answer 1

a) PPP means Purchasing Power Parity

According to IMF , PPP definition is

The rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods and services in each country.

Assumptions:

The consumptions baskets are the same in both countries and contain identical goods.

Trade barriers and transportation costs are low

Assupmtions break because consumption products are different in different countries.

There will be some trade barriers.

Actually PPP can be used to find which country's currency is overvalued or undervalued in comparison to other countries.

Example is suppose a pen costs in US a $ 1 , it means that in India it should cost INR 70 but in India it actually costs INR 10. So PPP says that it should cost same in both countries, it doesnt mean that the exchange rate should be equal to one. It states that the ratio of price to exchange rate should be one.

b) Real Exchange Rate

Its nothing but the price of domestic goods in terms of foreign currency.

If purchasing power parity held exactly, then the real exchange rate would always equal one.

For example presently $ 1 is equal to INR 69 it means if i want to buy a dollar I have to pay 69 rupees. So here dolar is superior to rupee. conversely if you want to buy a rupee one has to pay 1/69^th of dollar.