Question

What are the theoretical problems with purchasing power parity theory in determining exchange rates?

Answer 1

Purchasing Power Parity
The Law of one price states that identical or exactly the same goods or services should have same price in all the locations. If there is a difference, then this creates a potential for arbitrage i.e. buying from the place where the price is low and selling it at the place where the price is high.
There should be an adjustment made in the currencies of 2 different locations such that the purchasing power of both the location should be the same.

Limitations are

1) Weights of Inflation Indices are different in different countries
Purchasing Power Parity (PPP) takes inflation into consideration. And inflation is calculated using a basket of goods and services. However, the weightage given for each good and service will be different in different countries and hence, the inflation number won't be comparable.

2) Ignore other factors
PPP theory considers inflation only and no other factors such as demand and supply, trade balance, interest rates, etc.

3) True in Long term
The theory holds true in the long-term. However, it is not defined what long-term means and it can't be used to calculate short term outlook of a pair of currencies

4) Assume Free Trade
The theory assumes that there is free trade that goes on between 2 different countries. However, that is not possible in today's world where there are various trade barriers such as import duty, quota restrictions, ban on certain goods, etc.