Question

2.Analyze purchasing power parity, both absolute and relative versions.

Answer 1

Purchasing Power Parity theory suggests that the consumer demands for equivalent purchasing power of different currencies in order to retain purchasing power parity across countries. The purchasing power parity theory is based on one price theory.

The absolute purchasing power parity theory suggests that identical goods should have the same price in two separate markets, if there are no transportation costs and applicable tax rates are same in both markets. Therefore the exchange rate between two counties is based on the average costs of goods and services of that countries.

The relative purchasing power parity theory suggests that there is a relationship between the inflation rate of two countries because it is associated with price of goods or services of that country and it influence the changes in the spot exchange rate of that countries.