Purchasing Power Parity

Determination of Exchange Rates

The factors that affect the exchange rate, with price differentials being the primary factor in the long run and interest rate differentials in the short run.

Law of One Price (LOOP)

The concept that goods cost the same everywhere in the world when expressed in the same currency, based on the idea of arbitrage equalizing prices.

Absolute Purchasing Power Parity (PPP)

Extends the LOOP to the general price level, stating that the general price level is the same everywhere in the world when expressed in the same currency.

PPP as a Theory of the Nominal Exchange Rate

PPP assumes that the price level in one country is equal to the exchange rate multiplied by the price level in another country, allowing for the calculation of the nominal exchange rate.

Quantity Theory of Money

A macroeconomic theory explaining the determination of the price level in the long run, stating that money demand is a constant times nominal GDP.

Determination of the Price Level

The price level is directly related to the money supply and inversely related to money demand and real GDP.

Quantity Theory of Money and PPP Combined

The combination of PPP and the quantity theory of money to determine the exchange rate.

Reasons why PPP does not hold in the short run

Transactions costs, nontraded goods, imperfect competition, excise taxes, and price stickiness.

Real Exchange Rate

The ratio of the cost of a basket of goods in a foreign country to the cost in the home country, expressed in a common currency.

Net Exports and the Real Exchange Rate

Net exports depend more on the real exchange rate than the nominal exchange rate, as the relative prices of domestic and foreign goods determine the decision to purchase.

Relative Purchasing Power Parity

Assumes that the relative price differences between countries are constant over time, allowing for predictions about the determinants of the exchange rate.

Example of Relative PPP

An example showing how the relative difference in the cost of living between two countries can be constant over time.

Inflation Review

The growth rate of prices, with an example illustrating how inflation affects the price of an item.

Relative PPP and Inflation

The relationship between relative PPP and inflation, with the inflation differential being equal to the percentage change in the exchange rate.

Comparison of Absolute PPP and Relative PPP

Absolute PPP predicts the level of the exchange rate, while relative PPP predicts the change in the exchange rate.

Relative PPP

A theory in economics that states that the exchange rate between two countries should adjust to reflect changes in the price levels of those countries.

Inflation

The rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling.

Exchange rate

The value of one currency for the purpose of conversion to another.

Depreciation

A decrease in the value of a currency in relation to other currencies, leading to a decrease in the exchange rate.

Equilibrium price

The price at which the quantity demanded of a good or service is equal to the quantity supplied, resulting in a stable market price.