purchasing pp
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Introduction to Purchasing Power Parity (PPP)
Purchasing power parity (PPP) is one of the oldest models of exchange rate determination. The theory PPP states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. It means that the transaction on a country's current account affects the value of the exchange rate on the foreign exchange market.
Economists use two versions of Purchasing Power Parity: absolute PPP and relative PPP. Absolute PPP refers to the equalization of price levels across countries.
Relative PPP refers to rates of changes of price levels, that is, inflation rates. This proposition states that the rate of appreciation of a currency is equal to the difference in inflation rates between the foreign and the home country. This proposition holds well empirically especially when the inflation differences are large.
The basis for PPP is the "law of one price", so it is best, first, to review the idea behind the law of one price, to explain the theory PPP.
The Law of One Price (LoOP)
The law of one price is given as follows:
P1 = P2 x S (Equation 1)
P1: the price of good 1 in the domestic country
P2: the price of good 1 in the foreign country
S: the exchange rate
The equation states that the price of good 1 (in the domestic currency) in domestic country must be equal to the price (in domestic currency) in foreign country...