Question

<Purchasing power parity>

Q. In a market where PPP Does Not exist, Explain the short & long run changes in the Exchange rate, Interest rate and Price, when Money Supply decreases.

Q. In a market where ppp holds, explain the short & long changes in the Exchange rate, Interest rate and Price, when the Money growth rate is decreased.

Answer 1

When PPP Holds:-

Purchasing power parity is an economic theory for measuring prices at different locations. It is based on the Law of One Price, which says that, if there are no transaction costs nor trade barriers for a particular good, then the price for that good should be the same at every location. So, in the ideal, a computer in New York and in Hong Kong should have the same price.

The value of the PPP exchange rate is very dependent on the basket of goods chosen. In general, goods are chosen that might closely obey the Law of One Price. So, ones traded easily and are commonly available in both locations. Different organizations that compute PPP exchange rates use different baskets of goods and can come up with different values.

Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When a country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must depreciated in order to return to PPP.

The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency. For example, a particular TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver. If this process (called "arbitrage") is carried out at a large scale, the US consumers buying Canadian goods will bid up the value of the Canadian Dollar, thus making Canadian goods more costly to them. This process continues until the goods have again the same price. There are three caveats with this law of one price. (1) As mentioned above, transportation costs, barriers to trade, and other transaction costs, can be significant. (2) There must be competitive markets for the goods and services in both countries. (3) The law of one price only applies to tradeable goods; immobile goods such as houses, and many services that are local, are of course not traded between countries.