Question

Consider floating exchange rate.

Why the absolute purchasing power theory is deficient?

Answer 1

Absolute PPP theory is deficient, because it does not consider the presence of transportation cost in the trade of goods and services that affect the adjustment process of floating exchange rates. It causes final exchange rate under floating rate mechanism to be different than the absolute PPP has calculated. Further, absolute PPP  relies on the value of national basket of goods and services to adjust the exchange rate, but it does not consider the quality of goods that can vary in different countries. Hence, price is not the correct indicator of value of the basket of goods, rather it is the quality and consumers preference of goods that can affect the value. But, these factors are also not considered by absolute PPP. Hence, resulting exchange rate under absolute PPP is different to the actual exchange rate, prevailing in the Forex market. It makes absolute PPP to be deficient.