Discuss PPP, its theoretical perspectives and empirical evidence
- What is the PPP?
- The empirical limits of purchasing power parity methods.
In an international and globalize environment such as the national economies are growing in, it is hard to measure and evaluate the performances of each one in comparison with the others. Indeed, currencies are different all around the world and to what we can or cannot afford or in a foreign country with our national currency, we need to measure the purchasing power between a national currency and a foreign currency. Some economists have tried to build two principal tools to compare two economies performances. The first one takes in account and compares the nominal exchange rates on the exchange market between two different currencies. This method is the simplest one and gives an approximation of the real performances of two economies. Empirically, this method has shown a lot of limits and inaccurate results, which takes us to the second method. This one makes a comparison of the purchasing power that a home currency offers in a foreign currency. This tool is called the Purchasing Power Parity.
[...] The empirical limits of purchasing power parity methods In opposition to the of one price?, we cannot deny that in reality, transport costs exist and are combined with trade costs and trade barriers. Indeed, they make the exchange flows more expensive and change the trade flows, which threatens the of one price? brought by Ricardo. These additional costs break the close relationship between the level of prices and the exchange rates. In fact, the bigger the transport costs are, the bigger the gap where the exchange rate can vary is. [...]
[...] It can be logged as: log = log log(Pf) = This equation compares the nominal depreciation rate and the inflation rate difference. In this method, the real exchange rate has to be equal to the unit. Q can be logged as: Q = S. Pf/Ph log = log(S) + log log(Ph) To be verified, following this equation, log has to be equal to 0 and then that the real exchange rate has to be equal to the unit. Which means that the real exchange rate holds (which is quasi-impossible). [...]