In Chapter 1, we looked at what exactly the foreign exchange market is, introduced a number of differing exchange rate concepts and examined a simple current account model of exchange rate determination. In this chapter we look at one of the earliest and simplest models of exchange rate determination known as purchasing power parity (PPP) theory. An understanding of PPP is essential to the study of international finance. PPP theory has been advocated as a satisfactory model of exchange rate determination in its own right, and also provides a point of reference for the long-run exchange rate in many of the modern exchange rate theories which we examine in later chapters.
Having looked at PPP theory, we proceed to examine how well-suited this theory is to explaining actual exchange rate behaviour since the adoption of generalized floating in 1973. As we shall see, PPP theory does not provide an adequate explanation of some of the observed features of floating exchange rates. Some of the possible explanations for the failure of PPP are then discussed.
Explain what you understand by purchasing power parity theory. How do you account for its poor performance at explaining exchange rate movements since 1973?
Explain the difference between absolute PPP and relative PPP. How might the distinction between traded and non traded goods be relevant to testing for PPP?
Discuss the statistical problems that make testing PPP hard to test empirically. Is the empirical evidence supportive of the PPP theory?
“PPP is not just a theoretical concept it is useful as a measure of the relevant importance of different economies and per capita GDPs compared to using market exchange rate.” Discuss.
Explain with reference to the Balassa -Samuelson model why it is that the price of non traded goods are cheaper in developing countries than in developed nations.
