Purchasing Power Parity

The question of, “does relative purchasing power parity hold?” is one of great interest to economists. It is of interests to economist because it involves the percentage change of exchange rates and the difference between the percentage changes in national price levels. The definition of relative purchasing power parity is, “the percentage change in the exchange rate between two currencies over any period equals the difference between the percentage changes in national price levels” (Krugman 416). This is important to economists because it allows them to examine change in exchange rates and the percentage changes in prices to help predict what will happen next in the economies. Not only can economists compare the percentage change in exchange rates and changes in national prices but they can also compare the percentage change in exchange rate with differences in inflation between two countries. A lot of factors can come into play when talking about relative purchasing power parity. These factors are exchange rates, inflation rates, purchasing power parity, law of one price and real interest rates. All of these things come into play when an economist is trying to predict future prices or what the economy will do next when in regards to the economies of two different countries. Before talking more about relative purchasing power parity, it is important to cover purchasing power parity on its own. Purchasing power parity is, “the movements in the exchange rate between two countries’ currencies by changes in the countries’ price levels” (Krugman 413). Basically, when talking about purchasing power parity, you are examining changes in exchange rate and with changes in price levels. This is important when talking about the law of one price. The law of one price is when a good or a basket of goods in one country is the same price as in another country. It is important to note that the law of one price does not account for transportation costs or tariffs that are put in place. Because of that it is safe to say that purchasing power parity does not hold. In the world today, it is obvious that there are shipping costs and barriers to trade. When it comes to relative purchasing power parity things get different. As mentioned in the introduction, relative purchasing power parity talks about exchange rate and price changes as opposed to absolute purchasing power parity which talks about exchange rate and price levels. …show more content…
Both Purchasing power parity and absolute purchasing power parity do not hold in any situations in the economy. This allows economists to come to the conclusion that both these versions of the purchasing power parity do a poor job at explaining data. Although relative purchasing power parity also does not do a great job at explaining data, it does a better job than the other two in terms of the long run. An example form the book shows that it too does not do a great job in this situation. The example is, “Relative PPPP predicts that E¥/$ and PJ / PUS will move in proportion but, clearly they do not” (Krugman 423). Now that we have talked about factors such as purchasing power parity, the law of one price and how all three purchasing power parity explain data we can move on to determining if relative purchasing power parity holds. In the short run, none of the purchasing power parity’s hold because the exchange …show more content…
With the knowledge of exchange rates changes and price changes, economist can predict what may happen next in the world using the relative purchasing power parity. The reason that relative purchasing power parity is better than the other two is because neither of them really take into account barriers to trade and the transportation costs. Although using relative purchasing power parity to describe data is not the best way, it is better than the other two.

Works Cited
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