International parity violations (add later maybe) Flashcards
What is PPP
purchasing power parity
-equilibrium value of a currency based upon is purchasing value in different countries
-Idea is that prices in different countries once converted to a common currency should be equal
What are the three PPP concepts?
- Law of one price (individual goods)
- absolute PPP (general price level)
- Relative PPP (changes in general price level aka inflation)
What is law of one price
prices of identical goods traded in different markets should be the same
If two identical goods are prices differently in two countries, everyone will buy the cheaper one which causes the price to increase and vice versa.
By comparing identical goods denominated in different currencies we could determine real or PPP exchange rate (no frictions)
What is absolute purchasing power parity?
If law of one price true for all G/S.
Two identical baskets of goods should be the same.
Does ppp hold irl?
In short term, not realy, capital markets adjust much faster than prices of goods
Why does PPP not hold?
Different construction of price indices (representative bundle)
Taste differences
Non-tradable goods
Transaction costs
Restrictions on trade (tarrifs)
What is relative purchasing power parity?
Exchange rate movement should reflect changes in price levels between two countries over a certain time
What are the effects on world trade if PPP does not hold/
- Competitiveness abroad is affected by nominal changes in exchange rates
- currencies exchange rates need to be evaluated against other currencies to determine relative PP
- Objective is to discover if exchange rate is under or over valued
Why do we care about PPP?
- Economy: large deviations from PP casue an imbalance between exports and imports and large CA deficits or surpluses
- For firm: Information about its competitive position with respect of firms in other countries
