Question

Why might it be true that relative PPP holds better in the long run than the short run? (Think about how international trading firms might react to large and persistent crossborder differences in the prices of a tradable good.)

Short answer

Relative PPP tends to hold better in the long run because international trading firms respond to cross-border price differences by arbitraging goods, which takes time. This gradual adjustment of supply and prices leads to alignment in exchange rates and price levels that is more consistent with relative PPP in the long run than in the short run.

Step-by-step solution

Understanding Relative PPP

Relative Purchasing Power Parity (PPP) suggests that the rate of change in exchange rates between two countries' currencies over a period of time should equal the difference in the inflation rates of those countries over the same period. This concept expects a country with a higher inflation rate to see its currency depreciate relative to a currency of a country with lower inflation. Start by understanding this theoretical underpinning.

Considering Time Frames

Recognize that the short run and long run have different characteristics in economics. In the short run, prices and exchange rates are often sticky due to contracts, menu costs, and other adjustment frictions. In the long run, these prices can adjust fully to reflect changes in economic fundamentals.

Incorporating Market Response

Consider how international trading firms adjust to price differences. If there are large, persistent cross-border price differentials for tradable goods, firms will increase their supply in the country with higher prices (or reduce the supply in the country with lower prices), leading to an arbitrage opportunity. Over time, this response works to equalize prices across borders, bringing relative PPP into alignment.

Assessing Impact of Adjustments

Understand these adjustments can take time due to transportation costs, trade barriers, and information costs, making relative PPP more likely to hold in the long run. As firms and consumers adjust to international price differences, changes in exchange rates are influenced, thus reflecting the long-run tendency towards relative PPP.

Key concepts

Exchange Rates

Understanding how currencies are valued in comparison to each other is fundamental to grasping the dynamics of international economics. Exchange rates represent the price at which one currency can be exchanged for another. These rates fluctuate constantly due to various factors including, but not limited to, economic indicators, market sentiment, and geopolitical events.

Considering relative Purchasing Power Parity (PPP), exchange rates adjust to neutralize the effects of inflation between two countries. For instance, if the United States experiences higher inflation than the Eurozone, the relative value of the US dollar should decrease in relation to the Euro over time. In other words, each dollar would buy fewer Euro-denominated goods, reflecting the loss in purchasing power caused by inflation.

Exchange Rate Mechanisms in the Short vs. Long Run

While in the short run, exchange rates might not fully reflect the inflation differentials due to 'stickiness' or market interventions, the long run usually shows a stronger correlation. Over extended periods, markets tend to adjust, with the exchange rates aligning more closely with the inflation rate differentials, as suggested by relative PPP.

Inflation Rates

Inflation plays a pivotal role in determining the purchasing power of a currency. An inflation rate measures how fast prices for goods and services rise over a particular period, usually expressed as a percentage. Higher inflation means that consumers can buy fewer goods and services for the same amount of money, indicating a decrease in purchasing power.

When we relate inflation to the concept of relative PPP, it becomes evident that a country with higher inflation would generally see its currency depreciate relative to its trading partner whose inflation is lower. This depreciation occurs because, in theory, traders and consumers seek to maximize the value of their money, and they do so by engaging in international trade where goods are relatively cheaper.

Understanding Inflation Impact on Trade and Currencies

Over time, inflation differentials can lead to significant shifts in international trade flows and investment. As businesses and investors look for opportunities to capitalize on price differentials, the resulting demand for currencies changes, affecting the exchange rates. The link between inflation and currency values is intrinsic to the concept of PPP and is more pronounced over the long term as economies adjust to sustained changes in price levels.

International Trade

The movement of goods, services, capital, and labor across borders is what we call international trade. It's a driving force of the global economy, facilitating economic growth, and promoting efficiency and innovation through competition and exchange.

International trade is profoundly influenced by relative price levels of tradable goods across countries. If a product is cheaper in Country A than Country B, businesses will tend to import from Country A to sell in Country B, exploiting the price differential for profit, a process known as arbitrage. According to the theory of relative PPP, any persistent discrepancy in prices between countries should be neutralized by changes in the exchange rate over time.

Role of PPP in Balancing International Trade

When firms respond to price discrepancies by trading across borders, they increase the supply where prices are higher, eventually leading to a stabilization of prices. This gradual process supports the relative PPP, as it brings the prices of comparable goods into balance when accounting for exchange rates. However, structural factors like tariffs, transportation costs, and trade quotas can delay this balancing effect. In the long term, as these frictions are overcome or minimized, international trade flows adjust, and relative PPP holds more consistently.