Purchasing Power Parity (PPP)

A Theory of Exchange Rates

Purchasing Power Parity

when a unit of any given currency should be able to buy the same quantity of identical goods in all countries

real, one

Under the assumption of purchasing power parity, the ? exchange rate should equal ?

theoretical, long, short, speculation, adjusting, local

purchasing power parity is a ? scenario that only exists in the ?-term

• doesn’t exist in the ?-run since, in reality, there’s always market ? and ? exchange rates based on the relative purchasing power of ? currencies

Law of One Price

Law that states that a good must sell for the SAME PRICE in all locations… otherwise an opportunity for exploitation exists

Arbitrage

taking advantage of different prices in different markets due to the law of one price

theory, transportation, trade, competitive

The law of one price exists only in ?

• doesn’t account for ? costs

• doesn’t account for goods / services you can’t ?

• assumes markets are perfectly ?

profit, export, rise, equal

THEORETICALLY, let’s say one USD can buy more donuts in the US than in Germany

1. to make a ?, we’ll buy donuts from the US and sell them in Germany

2. eventually, we’ll ? so many donuts that the price of donuts in the US will actually ?

3. at some point, the price of donuts in the US should ? the price of donuts in Germany

price, nominal, money, domestically, abroad

when ? levels change, ? exchange rates change as well

• this means that ? supply changes affect the value of money both ? and ? (through interest rates)

increases, weaker, domestically, abroad

if the Fed ? the money supply (buying bonds, lowering RR / DR), the dollar becomes ? both ? and ?

decreases, stronger, domestically, abroad

if the Fed ? the money supply (selling bonds, raising RR / DR), the dollar becomes ? both ? and ?

policies, higher, appreciates

Weirdly enough, one currency like USD can appreciate in some countries while depreciating in others

• this is because of constant market speculation and hundreds of central banks pursuing different monetary ?

• for example, a country with a ? inflation rate than the US would make the USD ?

can’t, traded, normal

one limitation of purchasing power parity is that

• some goods / services just ? be easily ?

• hence, price differences are pretty ?

  • can’t really trade housing, medical care, utilities, labor, education, etc.

substitutes, higher

one limitation of purchasing power parity is that

• some tradable goods / services are not perfect ? for each other

  • consumer preference for ? priced items since they’re usually seen as a sign of “quality”