Question

What is purchasing power parity? Why might it not hold?

Answer 1

• Macroeconomic analysis heavily depends on various measures in order to compare economic productivity and standards of living between the countries. One of the method is Purchase Power Parity or PPP. This is an economic theory that compares different countries' currencies through a "basket of goods" approach. According to this theory,taking in to account two countries,their currencies are in equilibrium,if the price of particular basket of goods is same in both countries,while considering the exchange rate.
• There are many downfalls for PPP:
  • Transport cost: The goods which are unavailable in a country should be imported. Due to transportation charges there will be an increase in price of imported goods. Thus ,these goods can't be sold at same rate.
  • Taxes: The sales taxes imposed by government ,that is ,value added tax,can increase the price of goods. This can spike the cost of goods in one country,when compared to another.
  • Government interventions: Tariffs imposed by government can augment the price of imported goods,which can be purchased at a cheaper rate in other countries.
  • Market Competition: The goods will be sometimes sold at a higher price because a company will have a competitive advantage when compared to other sellers either they may have a monopoly,or because it is a cartel of companies that manipulate the prices.