Purchasing Power Parity Essay Example | Topics and Well Written Essays - 1000 words

Purchasing Power Parity - Essay Example It states that the country which is having high inflation rate is weak in terms of currency because inflation reduces the real purchasing power of a nation’s currency. It predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period which means that the exchange rate of two currencies reflects the effect of inflation rate (Murphy, p.1). Absolute PPP states that the value of 2 currencies changes in contrary proportion to the changes in the ratio of price levels. On the other hand relative, PPP predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period. Absolute PPP is based on the law of one price that is tested for a basket of commodities or individual commodities. The relative PPP approximates the change in individual price by change in pr ice indices. Empirical evidence of absolute PPP: An orange costs 3 dollars in country A and the same orange costs 6 dollars in country B. This means 3 dollars in country A equals to 6 dollars in country B. This exchange rate is based on the cost of orange and it is assumed that the cost of orange is same worldwide. Empirical evidence of relative PPP: Japan’s anticipated annual rate of inflation is equal to 6% per year, while the anticipated annual inflation rate for the U.S. is 3%. As an approximation, it is expected that the Japanese yen would devalue at the rate of 4% a year. The whole concept is based on unrealistic assumptions. That’s why forex market does not take into consideration the purchasing power parity. Those assumptions were a basket of goods and services in the CPI is the same in all countries, no transportation cost, and consumptions patterns are the same all over the world.