key term - Absolute Purchasing Power Parity (Absolute PPP)

Definition

Absolute Purchasing Power Parity (Absolute PPP) is an economic theory that states the exchange rate between two currencies should equal the ratio of the two countries' price levels, such that a unit of currency in one country can purchase the same amount of goods and services in another country. It is a measure of the relative cost of living and standard of living between countries.

5 Must Know Facts For Your Next Test

1. Absolute PPP suggests that the exchange rate between two currencies should equal the ratio of the price levels in the two countries, assuming no barriers to trade.
2. Absolute PPP is based on the law of one price, which states that identical goods should cost the same in different countries when prices are expressed in the same currency.
3. Deviations from absolute PPP can be attributed to factors such as transportation costs, tariffs, and other trade barriers that prevent the law of one price from holding.
4. Absolute PPP is a useful benchmark for comparing the standard of living between countries, as it measures the relative purchasing power of currencies.
5. Empirical studies have shown that absolute PPP often does not hold in practice, as real-world markets are not perfectly efficient and there are many impediments to the free flow of goods and services across borders.

Review Questions

• Explain how the concept of absolute PPP relates to the demand and supply of foreign exchange markets.
  • Absolute PPP states that the exchange rate between two currencies should equal the ratio of the price levels in the two countries. This means that if the price level in one country is higher than the other, the currency of the higher-priced country will need to depreciate relative to the currency of the lower-priced country in order to maintain the same purchasing power across borders. In the context of foreign exchange markets, this implies that changes in the relative price levels between countries will shift the demand and supply of their respective currencies, leading to adjustments in the exchange rate to restore the absolute PPP condition.
• Describe how deviations from absolute PPP can be explained by factors related to international trade and market frictions.
  • Absolute PPP assumes a frictionless world with no barriers to trade, but in reality, there are various impediments that can cause deviations from this theoretical benchmark. Factors such as transportation costs, tariffs, quotas, and other trade barriers can prevent the law of one price from holding, as they make it more difficult for goods and services to flow freely across borders. Additionally, market inefficiencies, information asymmetries, and the presence of non-tradable goods and services can also contribute to differences in price levels between countries, leading to exchange rates that deviate from the absolute PPP condition.
• Evaluate the usefulness of absolute PPP as a tool for comparing the standard of living and purchasing power between countries, given the practical limitations of the theory.
  • While absolute PPP provides a useful benchmark for comparing the relative purchasing power and standard of living between countries, it has significant limitations in practice. Empirical studies have shown that absolute PPP often does not hold due to the presence of various market frictions and impediments to trade. Additionally, the basket of goods used to calculate price levels may not be representative of the actual consumption patterns of consumers in different countries. As a result, absolute PPP may not accurately reflect the true differences in the cost of living and purchasing power across borders. However, it remains a valuable conceptual framework for understanding the factors that influence exchange rates and can provide insights into the relative competitiveness of economies, even if it does not perfectly predict actual exchange rate movements.

Related terms

Relative Purchasing Power Parity (Relative PPP):

Relative PPP is a theory that the exchange rate between two currencies is determined by the ratio of the two countries' price levels, and that this exchange rate will adjust to maintain equality in the purchasing power of the two currencies.

Law of One Price: The law of one price states that in an efficient market, identical goods must have only one price when their prices are expressed in the same currency.

Exchange Rate:

The exchange rate is the price of one currency expressed in terms of another currency, or the rate at which one currency can be exchanged for another.