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purchasing power parity (PPP) theory

which attempts to quantify the
relationship between inflation and the exchange rate. This theory supports the notion
developed in Chapter 4 about how relatively high inflation places downward pressure
on a currency’s value, but PPP is more specific about the degree by which a currency
will weaken in response to high inflation.


absolute form of PPP

in the absence of international barriers, consumers will shift their demand to wherever prices are lowest. The implication is that prices of the same basket of goods in two different countries should be equal when measured in a common currency. If there is a discrepancy in the prices as measured by such a common currency, then demand should shift so that these prices converge.


absolute form of PPP is sometimes considered unrealistic because

The existence of transportation costs, tariffs, and quotas render the absolute form of PPP unrealistic.
also we are assuming basket has substitute goods


ef = (1 + Ih) / (1+If) - 1

if Ih > If then ef

implies that the foreign currency will appreciate when the home country’s inflation exceeds the foreign country’s inflation. Conversely,


ef = (1 + Ih) / (1+If) - 1

if Ih < If then ef

Conversely, if Ih



difference in interest (rather than inflation)
rates to explain why exchange rates shift over time.