PPP

Question 1

• Law of one price:

Answer 1

Assumptions:
• presence of a competitive market structure

• Absence of transport costs and other trade
barriers

• Law of one price: “identical products which
are sold in different markets will sell at the
same price in terms of a common currency

Question 2

Generalised version of PPP:

Answer 2

• Distinction between traded and non- traded
goods
• Non- traded goods: cannot be traded
internationally

• Traded goods: can be traded internationally in
highly competitive markets

• PPP: more likely to hold in the case of traded
goods.

• Price of traded goods will keep in line with
international competition

• Price of non- traded goods: determined by
domestic supply and demand.

• Assumption: PPP holds for traded goods
• PT=SPT*

• PI= aggregate price index of the domestic
economy made up of a weighted average of
the prices of traded and non- traded goods.

α= proportion of non- traded goods in the
domestic price index
•
PI=αPN + (1-α) PT

• β = proportion of non- traded goods in
the rest of the world’s price index
• PI *= β PN * + (1- β) PT *

Question 3

Summary of empirical

evidence

Answer 3

• Frenkel (1981)
• PPP performs better for countries with geographic
proximity and strong links.
• Exchange rates are more volatile than national price
levels: Vs PPP hypothesis
• PPP holds better in the long run than in the short run
• 1980: countries with very high inflation rates
experienced rapid exchange rate depreciations: PPP:
dominant force in determining exchange rates
• PPP holds better for traded goods than for nontraded goods