PPP thus implies that the exchange rate is determined by the ratio of average prices.
dollar), then absolute PPP holds if P(CH) = E dollar exchange rate (number of francs per U.S. If P(CH) is the level of average prices in Switzerland, P(US) is the level of average prices in the U.S., and E is the Swiss franc/U.S. If absolute PPP holds, a typical basket of goods in country A has exactly the same price as it does in country B, when prices are expressed in a common currency.Ĭonsider the case of Switzerland and the United States: Purchasing power parity (PPP) is the application of LOP across countries for all goods and services-or for representative groups (“baskets”) of goods and services such as those used to compute the consumer price index. Intuitively, LOP holds because, if prices were lower in country A and higher in country B, people would simply buy the lower-priced good in country A and sell it in country B at a higher price. But what is PPP and what is the long run?Ī good starting point is the law of one price (LOP), which states that the same good in different competitive markets must sell for the same price, when transportation costs and barriers between those markets are not important. Most models in international macroeconomics assume purchasing power parity (PPP) holds in the long run.
#LIES OF P PRICE SKIN#
“Under the skin of any international economist lies a deep-seated belief in some variant of the PPP theory of the exchange rate.” - Dornbusch and Krugman (1976)
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