Question

Essay question: Explain Purchasing Power Parity and show how it can used to explain foreign exchange rate movements.

Answer 1

Purchasing-power parity (PPP) is an economic concept that states that the real exchange rate between domestic and foreign goods is equal to one, though it does not mean that the nominal exchange rates are constant or equal to one.

Purchasing power parity (PPP) is a theory of exchange rate determination and a way to compare the average costs of goods and services between countries. The theory assumes that the actions of importers and exporters, motivated by cross country price differences, induces changes in the spot exchange rate. In another vein, PPP suggests that transactions on a country's current account, affect the value of the exchange rate on the foreign exchange market. This contrast with the interest rate parity theory which assumes that the actions of investors, whose transactions are recorded on the capital account, induces changes in the exchange rate.

Put another way, PPP supports the idea that identical items in different countries should have the same real prices in another, that a person who purchases an item domestically should be able to sell it in another country and have no money left over.

This means that the amount of purchasing power that a consumer has does not depend on what currency with which he or she is making purchases. The "Dictionary of Economics" defines the PPP theory as one that "states that the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent."

PPP theory is based on an extension and variation of the "law of one price" as applied to the aggregate economy. To explain the theory it is best, first, to review the idea behind the law of one price.