Question

What is purchasing power parity? Why might exchange rates deviate from purchasing power parity?

Answer 1

Answer:-

In its absolute version, purchasing power parity states that price levels should be equal worldwide when expressed in a common currency. In other words, a unit of home currency (HC) should have the same purchasing power around the world. The relative version of purchasing power parity, which is used more commonly now, states that the exchange rate between the home currency and any foreign currency will adjust to reflect changes in the price
levels of the two countries. For example, if inflation is 5% in the United States and 1% in Japan, then the dollar
value of the Japanese yen must rise by about 4% to equalize the dollar price of goods in the two countries.

some reasons for deviations from purchasing power parity:-

• The price indices used to measure PPP may use different weights or different goods and services.

• Arbitrage may be too costly, because of tariffs and other trade barriers and high transportation costs, or too risky, because prices could change during the time that an item is in transit between countries.

• Since some goods and services used in the indices are not traded, there could be price discrepancies between countries.

• Relative price changes could lead to exchange rate changes even in the absence of an inflation differential.

• Government intervention could lead to a disequilibrium exchange rate.