Question

The most widely accepted theory of foreign exchange rate determination is purchasing power parity, yet it has proven to be quite poor at fore- casting future spot exchange rates. Why? Please try to meet 450 words, thank you so much!

Answer 1

Purchasing power parity theory- This theory is an economic theory that studies the purchasing power of two different countries on the basis of some basket of goods. This theory tells the standard of living of two countries that are altogether different. This theory says that two different currencies are met at an equilibrium when the a basket of goods are priced similar in both the currencies.

Formula: S = P₁/P₂

Where; S = Exchange rate of Currency 1 to currency 2

P₁ = Cost of goods in currency 1

P₂ = Cost of goods in currency 2

Advantage of PPP- This theory studies the market and economic conditions of two countries that are helpful in international business and policies. This theory also determines the exchange rates.

Yet it has proven to be quite poor at fore- casting future spot exchange rates. Why?

Yes, this is correct, PPP theory has proven to be quite poor at fore-casting spot exchange rates. It is not an accurate theory, it is just incomplete. This theory has many limitation that are as following:

1. Economic conditions are not same of two countries.
2. Goods are not traded easily and they do not have perfect substitutes.
3. Indices are calculated by some good or commodities not all the commodities.
4. Consumers taste keep on changing so basket of goods cannot be compared.
5. In this theory, economist has to calculate the base rate which is difficult to get accurate in two countries.