Purchasing power parity Essay Example | Topics and Well Written Essays - 1750 words

Purchasing power parity - Essay Example bsolute purchasing power parity to distinguish it from a related theory relative purchasing power parity, which predicts the relationship between the two countries relative inflation rates and the change in the exchange rate of their currencies (Wikipedia, 2006). It is important in international economics for at least three reasons. First, it provides a particularly simple theory of exchange rate determination: it predicts that, if the relative price of two currencies is flexible, then it will adjust to equal the ratio of their price levels. Second, if this kind of adjustment does not take place, the ratio of price levels can nonetheless provide a reference point against which the current exchange rate can be deemed to be "under- or over-valued" relative to its PPP level. Finally, irrespective of whether PPP will ever occur in practice, deviations from it must be taken into account in making international and interregional comparisons of real income (Neary, 2004). The theory assumes that the actions of importers and exporters, motivated by cross country price differences, induces changes in the spot exchange rate. In another vein, PPP suggests that transactions on a countrys current account, affect the value of the exchange rate on the foreign exchange market. This contrast with the interest rate parity theory which assumes that the actions of investors, whose transactions are recorded on the capital account, induces changes in the exchange rate (Suranovic, 1999). Although earlier studies, like Froot and Rogoff (1995) had reported evidence of short run violations, many economists as Mc Donald (1996), Wu (1996) and others still hold the view that over the long run, relative price may move in proportion to the nominal exchange rate so that the real exchange rate will revert to its parity. Hence, it becomes important to test PPP as a long run relationship. PPP theory is based on an extension and variation of the "law of one price" as applied to the aggregate