Question

Explain the theory of purchasing power parity. Explain the limitation of purchasing power parity in fully explaining exchange rate movements.

Answer 1

In neoclassical economic theory, the purchasing power parity theory assumes that the exchange rate between two currencies actually observed in the foreign exchange market is the one that is used in the purchasing power parity comparisons, so that the same amount of goods could actually be purchased in either currency.

But, it exchange rates do not always move to ensure that a dollar has the same real value in all countries all the time.many goods are not easily traded and purchasing-power parity does not always hold is that even tradable goods are not always perfect substitutes when they are produced in different countries.

Because some goods are not tradable and because some tradable goods are not perfect substitutes with their foreign counterparts, purchasing-power parity is not a perfect theory of exchange-rate determination.