Purchasing Power Parity

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Introduction

Purchasing Power Parity (PPP) is one of the most important theories for determining exchange rate in the international finance. PPP is coined by Gustav Cassel in 1918, and this concept had been discussed by various economists. PPP theory explains that the change in the exchange rate between two currencies should be equal to the national price level when converted in a common currency; hence, a unit of one currency of the country will have the equal purchasing power in a foreign country. PPP can hold for all types of goods, but in practical, PPP is more likely to hold for tradable goods than non-tradable goods. The law of one price (LOP) is the basic fundamental concept of PPP. The law of one price stated that the identical product should sell for the same price which says that in the absence of trade barriers and transactions costs across the countries once converted the prices to a common currency. There are differences between LOP and PPP, LOP applies to individual product whereas PPP applies to the general price level. Today, various economists’ debate over PPP does not hold in the short run, it only holds in the long run. While only few economists believe PPP holds continuously in the real world. Contrary to PPP does not hold in the real world, economists stated that different countries’ goods are not perfect substitutes and international arbitrage is not possible as non-traded goods and transportation costs.
Does PPP holds in the short run and long run?

A study by Taylor & Taylor (2004) used Producer Price Index and Consumer Price Index (CPI) between two countries US and UK to test whether two versions of PPP hold in the real life. Absolute purchasing power parity (PPP) holds when the nominal exchange rate o...

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