Topic 7: Purchasing Power Models

Question 1

What are the two PPP models?

Answer 1

• Absolute
• Relative

Question 2

Define the absolute PPP Model.

Answer 2

A condition of equality of price levels between two different countries, once the countries different currencies have been taken into account using the exchange rate.

Question 3

Formulate the absolute PPP model

Answer 3

P = sum w_iP_i

P* is symetrical

We assume the law of one price holds for all goods, so that

Sum w_iP_i = S(d/f) Sum w*_iP*_i

P = S(d/f) P*

Question 4

What are the problems with the absolute PPP model?

Answer 4

Not all goods have equal price, because:

• Tariffs
• Transport costs / Trading Costs
• Other barriers to trade

Question 5

Formulate the relative PPP model

Answer 5

P = k S(d/f) P*

Where k is a measure of tarrifs, and is exogenous.

Thus percentage changes in P can be determined from changes in S(d/f) and P*, and so on.

%ΔP = %ΔS(d/f) + %ΔP*

Question 6

Evaluate the relative PPP model theoretically.

Answer 6

A good theory shows unambigous changes to endogenous variables.

But this model is very unspecified, there can only be one endogenous variable.

It seems likely that these variables (Prices, home and foriegn and S(d/f)) are going to depend on each other

Question 7

What has been the result of empirical analysis on the relative PPP theory.

Answer 7

Doesn’t match the data very well.

But people are still appear to be looking into it.