Answer to Question #153843 in Macroeconomics for Jason

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 economies.

Answer 1

According to the theory of purchasing power parity, the same amount of money, converted at the current exchange rate into national currencies, in different countries of the world can buy the same amount of goods and services in the absence of transport costs and restrictions on transportation.

If purchasing power parity is not observed in two countries, that is, if the exchange rate of the currency of country A to the currency of country B exceeds the parity value, it becomes profitable to buy goods in country B and export them to country A. This increases the supply of goods in country A, the demand for goods in country B, the demand for the currency of country B and the supply of the currency of country A, which leads to the return of rates to a parity ratio.