Lecture 5

Question 1

Absolute PPP?

Answer 1

• states that the exchange rate between two countries’ currencies equals the ratio of the countries’ price levels

Question 2

Law of one price?

Answer 2

• same good in different competitive markets must sell for the same price
• why? supply and demand: people will buy the cheaper variant, eventually causing prices to equalize
• identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency, assuming competitive markets free of transportation costs and official barriers to trade, e.g., tariffs
• applies to individual commodities

Question 3

Long run?

Answer 3

long run means enough time for prices of goods and services to adjust to market conditions

Question 4

Purchasing power parity?

Answer 4

• PPP is the application of the law of one price accross countries for all goods and services on average
• applies to the general price level

Question 5

Relative PPP?

Answer 5

• changes in exchange rates equal changes in prices, i.e., inflation, between two period