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Law of one price economics
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The limits of theory
Empirical studies have shown that the PPP theory is useful in predicting changes in nominal exchange rates over a relatively long period. In particular, this theory helps explain the tendency of countries with high inflation to record a depreciation of their exchange rates.
Why the theory of PPP is less effective in the short term than in the long? That it is based on the law of one price, which states that the price of a commodity traded at international levels must be the same everywhere. This law is effective with goods such as cereals or gold, which are characterized by standardized goods trade higher. However, not all goods and services are traded internationally, and not all goods are standardized goods.
Many goods and services are not traded internationally, because the hypothesis on the basis of the law of one price (which transportation costs are relatively low) does not apply in these cases. Examples of goods and services are not traded agricultural land, buildings, building materials (the value of which is low compared to the costs of transport) and ...
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