Question

Write an equation that describes purchasing power parity and explain the equation.

Short answer

Answer: The main idea behind Purchasing Power Parity is that identical goods should have the same price in different countries when expressed in a common currency. This is achieved when the exchange rate between two currencies is equal to the ratio of their respective price levels.

Step-by-step solution

Definition of Purchasing Power Parity

Purchasing power parity (PPP) is an economic theory that states that the exchange rate between two currencies is equal to the ratio of their respective price levels. In other words, it implies that identical goods should have the same price in different countries when expressed in a common currency.

Purchasing Power Parity Equation

The equation for purchasing power parity can be written as: \[ \frac{P_A}{P_B} = \frac{1}{E_{AB}} \] Where: - \(P_A\): is the price level of the basket of goods in Country A (in its local currency). - \(P_B\): is the price level of the same basket of goods in Country B (in its local currency). - \(E_{AB}\): is the exchange rate (the amount of Country B's currency needed to buy one unit of Country A's currency).

Breakdown of the Equation

1. Price level ratio: \(\frac{P_A}{P_B}\) shows the price level of the basket of goods in Country A relative to the price level of the same basket of goods in Country B. 2. Inverse of the exchange rate: \(\frac{1}{E_{AB}}\) represents the inverse of the exchange rate, which gives the amount of Country A's currency needed to buy one unit of Country B's currency. When the price level ratio is equal to the inverse of the exchange rate, it means that the purchasing power is the same for both countries, and goods are priced similarly when expressed in a common currency, which is the concept of purchasing power parity.