Lecture 5 PPP

Question 1

The purchasing power parity theorem asserts

Answer 1

that prices in one country should be equal to those in another country when expressed in a common currency. (absent transaction costs/barriers to trade).

When market rate deviates from PPP, suggests under or over valued compared to another on purchasing power basis.

Question 2

What is the PPP exchange rate?

Answer 2

The exchange rate that would make comparable goods sell for the same price in different countries

When comparable goods sell at different prices at market exchange rates, those exchange rates are away from their long-run or PPP values.

Question 3

Two implications of PPP

Answer 3

1) Changes in the nominal exchange rate should reflect changes in relative inflation rates on a one-to-one basis.

2) PPP theory maintains that real exchange rates are constant

(controversial because RER does fluctuate: market imperfections; non-traded goods (wages/rent), sticky prices, etc.

Question 4

What is the PPP exchange rate

Answer 4

It is the one that would make the same product (the Big Mac) sell for the same price in each country.