The idea of purchasing power parity
Select one:
a. always holds.
b. rarely holds.
c. explains why standards of living have changed over time.
d. explains how standards of living have changed over time.
The correct answer and explanation is:
The correct answer is: b. rarely holds.
Purchasing Power Parity (PPP) is an economic theory which suggests that in the absence of transportation costs and other trade barriers, the exchange rate between two currencies should adjust so that an identical good or service has the same price in both countries when expressed in the same currency. In simple terms, the theory suggests that currency exchange rates should be in equilibrium, reflecting the relative price levels between two countries.
However, in reality, PPP rarely holds true. This is because several factors can prevent the equalization of prices across different countries. These factors include:
- Transportation Costs: Goods cannot be instantly or cheaply transported across borders, leading to differences in prices that PPP doesn’t account for.
- Trade Barriers: Tariffs, quotas, and other restrictions imposed by governments can artificially alter the prices of goods between countries.
- Non-Tradable Goods: PPP primarily applies to tradable goods, but many goods and services are not internationally traded (e.g., housing, certain services), and their prices may differ significantly across countries.
- Market Imperfections: Differences in taxes, regulations, and even consumer preferences can result in price disparities that PPP doesn’t predict.
- Currency Controls: In some countries, governments impose controls on their currencies, which can distort exchange rates from the theoretical PPP value.
While PPP is a useful tool in understanding long-term trends in exchange rates, it is rarely accurate in the short run. Real-world data often shows deviations from the PPP prediction due to these economic frictions. Therefore, while PPP provides insight into relative price levels, it does not necessarily explain or hold up in everyday currency transactions.