Absolute ppp

Definition

Absolute purchasing power parity (PPP) is an economic theory which posits that in the absence of transaction costs and trade barriers, identical goods should have the same price when expressed in a common currency. This concept underlines the relationship between exchange rates and price levels across different countries, suggesting that exchange rates will adjust to equalize the purchasing power of different currencies.

5 Must Know Facts For Your Next Test

1. Absolute PPP assumes that there are no transportation costs or tariffs, allowing for a direct comparison of prices across countries.
2. The theory helps explain why exchange rates may deviate from their expected values based on differences in price levels.
3. Absolute PPP can be illustrated using the 'law of one price,' which states that identical goods should sell for the same price when converted into a common currency.
4. Empirical evidence often shows that absolute PPP holds better over long time periods rather than short ones due to market frictions.
5. While useful for understanding theoretical relationships, absolute PPP often fails in practice due to factors like product differentiation and local market conditions.

Review Questions

• How does absolute purchasing power parity provide insights into currency valuation?
  • Absolute purchasing power parity offers insights into currency valuation by suggesting that exchange rates should adjust to reflect price level differences between countries. If one country's prices are consistently lower than another's for identical goods, the theory predicts that its currency will appreciate until parity is achieved. This relationship provides a theoretical benchmark for assessing whether a currency is undervalued or overvalued based on price comparisons.
• Discuss how transportation costs and trade barriers challenge the validity of absolute purchasing power parity in real-world scenarios.
  • Transportation costs and trade barriers significantly challenge absolute purchasing power parity as they create discrepancies in prices across countries. When transportation costs are high or if tariffs are imposed, the cost of moving goods can prevent identical items from having the same price when converted to a common currency. These factors can lead to persistent deviations from what absolute PPP would predict, complicating its applicability in real-world trading situations.
• Evaluate the implications of absolute purchasing power parity for international investors making decisions about foreign currency investments.
  • For international investors, understanding absolute purchasing power parity is crucial as it provides a framework for evaluating potential currency movements and their impact on investment returns. If investors believe that a currency is undervalued according to PPP theory, they might choose to invest in assets denominated in that currency, anticipating appreciation. However, they must also consider real-world factors such as market inefficiencies and economic conditions that can influence actual exchange rates and investment outcomes, making a nuanced analysis necessary for effective decision-making.

Related terms

relative ppp: Relative purchasing power parity is the idea that the rate of change in prices between two countries will reflect the change in exchange rates over time.

exchange rate: The exchange rate is the value of one currency for the purpose of conversion to another, determined by market forces.

inflation: Inflation is the rate at which the general level of prices for goods and services rises, eroding purchasing power.