Question

What do you understand the concept of ”Absolute Purchasing Power Parity”? What does it mean when ”it holds”?

show the formula for ”Absolute Purchasing Power Parity” and state the reasons very briefly why it may not hold in Short Run

Answer 1

The concept of Absolute Purchasing Power Parity (APPP) is actually a reflection of law of one prices. When it holds, it means:

• Identical products should have identical prices in an efficient and perfect market.
• Identical products should have same price when measured in a common currency, in every part of world.
• Real exchange rates must remain constant and the constant value must be 1.
• Nominal exchange rates keep changing over time to ensure that real exchange rates = 1

Formula for APPP:

Domestic Price, P = Nominal exchange rate, S x Foreign Prices, P*

i.e P = S x P*

Reasons why APPP may not hold in Short Run:

• APPP is a macro level model and it presents a long-run equilibrium condition. Macro level parameters hold true in long run, they face many anamolies in the short run.
• In the short run, nominal exchange rates are usually very violatile making it difficult for absolute PPP to hold.
• Foreign prices, P* takes longer time to adjust or move in comparison to exchange rate, S. This is because asset trading is ignored.
• In short-run, the exchange rate market is impacted by capital and investments flows and hence APPP may not hold true in short run.