Absolute ppp

Definition

Absolute Purchasing Power Parity (PPP) is an economic theory that suggests that in the long run, exchange rates between two currencies will adjust to reflect the relative price levels of a basket of goods and services in the respective countries. This concept connects exchange rates to inflation and purchasing power, indicating that a currency's value should equal the price of a specific set of goods in different locations.

5 Must Know Facts For Your Next Test

1. Absolute PPP assumes that identical goods should have the same price when expressed in a common currency, disregarding transportation costs and tariffs.
2. It provides a benchmark for determining whether a currency is undervalued or overvalued based on the price of a similar basket of goods.
3. Absolute PPP does not hold perfectly in practice due to factors like market imperfections, local demand variations, and differences in consumption patterns.
4. The law of one price is an essential principle behind absolute PPP, which states that in an efficient market, identical goods must have the same price when converted to a common currency.
5. Countries with higher inflation rates will see their currencies depreciate over time compared to countries with lower inflation rates according to absolute PPP.

Review Questions

• How does Absolute Purchasing Power Parity explain the relationship between exchange rates and inflation?
  • Absolute Purchasing Power Parity explains that exchange rates adjust based on relative price levels, meaning that if one country experiences higher inflation than another, its currency will depreciate. This adjustment ensures that the price of a basket of goods remains consistent across different countries when expressed in a common currency. Therefore, Absolute PPP highlights how inflation affects currency value and international trade competitiveness.
• Compare Absolute PPP and Relative PPP in terms of their application to real-world scenarios.
  • Absolute PPP provides a theoretical framework suggesting currencies should equalize based on identical goods' prices, while Relative PPP focuses on how exchange rates change over time due to differing inflation rates. In real-world scenarios, Absolute PPP may not hold due to factors like transportation costs and tariffs, whereas Relative PPP can be more applicable as it accounts for ongoing economic conditions. Understanding both concepts helps analyze currency movements and market adjustments.
• Evaluate the limitations of Absolute Purchasing Power Parity in practical economic analysis.
  • Absolute Purchasing Power Parity has several limitations that make it less reliable for practical economic analysis. First, it assumes that all goods are perfectly tradable without any barriers like tariffs or shipping costs, which is rarely the case. Second, consumer preferences vary widely between cultures and regions, affecting demand and pricing. Lastly, market inefficiencies and information asymmetries can lead to discrepancies in prices across different markets, meaning Absolute PPP often fails to predict actual exchange rate movements accurately.

Related terms

Relative PPP: Relative Purchasing Power Parity is a concept that focuses on the changes in exchange rates over time, based on differences in inflation rates between two countries.

Nominal Exchange Rate: The nominal exchange rate is the rate at which one currency can be exchanged for another without considering the effects of inflation or purchasing power.

Real Exchange Rate: The real exchange rate adjusts the nominal exchange rate for differences in price levels between countries, reflecting the true purchasing power of currencies.