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Like the absolute Purchasing Power Parity version, the relative has its drawbacks.

y  It is difficult to determine the base period.

y  Trade restrictions are underestimated by this PPP

version too.

y  There are also long-term comparison problems because

the price index weighting is different and different

products are included in the indexes.

y  The exchange rate may diverge from the relative PPP

under the influence of a change in the internal price

ratios.

Finally, relative domestic and foreign prices experience a different movement as compared to spot

exchange rates. The commodity market conditions have no effect on the exchange rates over the

short term. However, financial market conditions play a major role on the movement of exchange

rates

 

PPP theory is a theory which states that exchange rates between currencies are in equilibrium when

their purchasing power is the same in each of the 2 countries. This means that the exchange rate

between 2 countries should equal the ratio of the two countries price level of a fixed basket of goods

and services. When a countrys domestic price level is increasing (i.e. experiencing higher inflation) that

countrys exchange rate must depreciate in order to return to PPP.

The basis for PPP is the law of one price. In the absence of transportation and other transaction costs,

competitive markets will equalize the price of an identical good in two countries when the prices are

expressed in the same currency. E.g. a TV that sells for 750 Canadian Dollars in Vancouver should cost

USD 500 in Seattle when the exchange rate between US & Canada is 1.50 CAD/USD. If the price of the TV

in Vancouver was only 700 CAD, consumers in Seatle would prefer buying the TV set in Vancouver.

There are three caveats with this law of one price:

1. Transporation costs, barriers to trade and other transaction costs can be significant

2. There must be competitive markets for the goods and services in both countries

3. The law of one price only applies to tradable goods; immobile goods such as houses and services

that are local, are of course not traded between countries.

One of the key problems is that people in different countries consumer very different sets of goods and

services, making it difficult to compare purchasing power between countries.

Uncovered Interest Rate Parity (UIP) Model: This model forecasts exchange rate movements in

accordance with returns from investment in the two curencies. The UIP creates an arbitrage

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mechanism that sets an exchange rate which equalizes returns from domestic and foreign

assets

Purchasing Power Parity (PPP) theory holds that in the long run, exchange rates will adjust toequalize the relative purchasing power of currencies. This concept follows from the law of one

price, which holds that in competitive markets, identical goods will sell for identical prices whenvalued in the same currency.

The law of one price relates to an individual product. A generalization of that law is the absoluteversion of PPP, the proposition that exchange rates will equate nations¶ overall price levels.

More commonly used than absolute PPP is the concept of relative PPP, which focuses onchanges in prices and exchange rates, rather than on absolute price levels. Relative PPP holds

that there will be a change in exchange rates proportional to the change in the ratio of the twonations¶ price levels, assuming no changes in structural relationships. Thus, if the U.S. price

level rose 10 percent and the Japanese price level rose 5 percent, the U.S. dollar woulddepreciate 5 percent, offsetting the higher U.S. inflation and leaving the relative purchasing

power of the two currencies unchanged.

PPP is based in part on some unrealistic assumptions: that goods are identical; that all goods aretradable; that there are no transportation costs, information gaps, taxes, tariffs, or restrictions of 

trade; and ²implicitly and importantly²that exchange rates are influenced only by relativeinflation rates.

But contrary to the implicit PPP assumption, exchange rates also can change for reasons other than differences in inflation rates. Real exchange rates can and do change significantly over time,

because of such things as major shifts in productivity growth, advances in technology, shifts infactor supplies, changes in market structure, commodity shocks, shortages, and booms.

In addition, the relative version of PPP suffers from measurement problems:What is a good

starting point, or base period? Which is the appropriate price index? How should we account for new products, or changes in tastes and technology?

PPP is intuitively plausible and a matter of common sense, and it undoubtedly has some

validity²significantly different rates of inflation should certainly affect exchange rates. PPP isuseful in assessing long-term exchange rate trends and can provide valuable information about

long-run equilibrium. But it has not met with much success in predicting exchange ratemovements over short- and medium-term horizons for widely traded currencies. In the short

term, PPP seems to apply best to situations where a country is experiencing very high, or even

hyperinflation, in which large and continuous price rises overwhelm other factors