Answer to Question #204802 in Macroeconomics for Orkhan

Question

Under what circumstances does purchasing-power parity explain how exchange rates are determined, and why is it not completely accurate?

Answer 1

(i)Purchasing Power Parity (PPP), an economic theory that allows for comparison of purchasing power of various world currencies to one another, can be used to show how exchange rate rate is determined when the following conditions are met;

• Identical market baskets can sell for identical prices in two different markets,
• when converted at the current exchange rate,
• that no transport costs are involved, and
• no differential taxes applied.

(ii)The PPP condition is too hypothetical rarely satisfied within a country such that its exchange rate may not match the market exchange rate since the market rate is more volatile as it reacts to changes in demand at each location. Tariffs on imports and differences in the price of labor are likely to contribute to long-term differences between the two rates.