Answer to Question #153434 in Macroeconomics for serin yong chin wei

Question

1)     Explain the meaning of purchasing power parity. Give an example of what will happen when purchasing power parity does not hold in two economy.

Answer 1

Purchasing power parity is a theory of exchange rate determination and a way to compare the average costs of goods and services between countries. It is a theoretical exchange rate that allows you to buy the same amount of goods and services in every country. Purchasing power parity doesn’t hold when there are transportation costs, trade barriers (e.g., tariffs), differences in prices of non-tradable inputs (e.g., rental space), imperfect information about current market conditions, and other Forex market participants. For example, the participation of other traders in the Forex market, who are motivated by other concerns, may lead the exchange rate to a value that is not consistent with PPP.