Question

Question 8:

If PPP held exactly, then the yen would trade at one yen to the dollar. True or False? Explain.

Answer 1

True

Purchasing power parity (PPP) is a neoclassical economic theory that states that the exchange rate between two countries is equal to the ratio of the currencies' respective purchasing power. Theories that invoke the purchasing power parity assume that in some circumstances (for example, as a long-run tendency) it would cost exactly the same number of, for example, US dollars to buy euros and then buy a market basket of goods as it would cost to directly purchase the market basket of goods with dollars. A fall in either currency's purchasing power would lead to a proportional decrease in that currency's valuation on the foreign exchange market.

The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be at par with the purchasing power of the two countries' currencies. Using that PPP rate for hypothetical currency conversions, a given amount of one currency thus has the same purchasing power whether used directly to purchase a market basket of goods or used to convert at the PPP rate to the other currency and then purchase the market basket using that currency. Observed deviations of the exchange rate from purchasing power parity are measured by deviations of the real exchange rate from its PPP value of 1.

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