Question

a. Absolute PPP doesn't do a very good job explaining exchange rates in the short run. Give and fully explain two of the three reasons for this failure.

b. Explain the difference between absolute and relative PPP.

Answer 1

Answer:-

(A). Absolute purchasing power parity does not always do a very good job. According to this the real price of products should be same across the country.

Now suppose the price of an item increase in country A x% but by y % in country B, but their currency exchange rate doesn't increase in the same proportionate, then country x becomes more attractive for trade than country y.thus country y losing its customer base as well as trade market.

According to this rule, the proportionate change in the exchange rate should be same as the proportionate change in price level. Or currency exchange ratio should be same as price level ratio in the two country, which is hypothetical. So the absolute Purchasing power parity fails on a lot of instances.

(B) differences between Absolute PPP and Relative PPP

Absolute purchasing power parity is the kind discussed in A Beginner's Guide to Purchasing Power Parity Theory (PPP Theory). Specifically, it implies that "a bundle of goods should cost the same in Canada and the United States once you take the exchange rate into account". Any deviations from this (if a basket of goods is cheaper in Canada than in the United States), then we should expect relative prices and the exchange rate between the two countries to move towards a level at which the basket of goods have the same price in the two countries.

The idea is expressed in more detail at A Beginner's Guide to Purchasing Power Parity Theory (PPP Theory).

Relative PPP

Relative PPP describes differences in the rates of inflation between two countries. Specifically, suppose the rate of inflation in Canada is higher than that in the US, causing the price of a basket of goods in Canada to rise. Purchasing power parity requires the basket be the same price in each country, so this implies that the Canadian dollar must depreciate vis-a-vis the U.S. dollar. The percentage change in the value of the currency should then equal the difference in the inflation rates between the two countries.
PPP Conclusion