Question

Explain the details of the purchasing power parity (PPP) theory.

Short answer

The PPP theory proposes that the exchange rate between two countries should equal the ratio of the two countries' price levels, ensuring a product costs the same everywhere once exchange rates are accounted for. It's influenced by factors such as goods restrictions, transportation costs, and differential taxes. It's useful for long-term exchange rate analyses but has limitations due to issues like non-substitutable goods, service sector differences, and the impact of costs and taxes.

Step-by-step solution

Explanation of Purchasing Power Parity

Purchasing Power Parity (PPP) is a theory that in absence of transaction costs and trade barriers, the exchange rate between two countries should equal the ratio of the two countries' price levels. More simply put, a product should cost the same everywhere once exchange rates are taken into account.

Factors That Influence PPP

Several factors to consider are differing goods restrictions (some things are more expensive in one country than another), transportation costs (moving goods around can cost money and increase the price of items), and differential taxes (tax rates may vary across countries, impacting the net price of goods)

Implications and Limitations of PPP

The theory can offer insights into the appropriate level for exchange rates for long term analyses. However, it should be used cautiously as, in reality, goods aren't always substitute and transportation costs and taxes can influence prices. Additionally, services are a significant part of an economy but they don't typically 'travel' and so may not conform to PPP.