What predictions does purchasing-power parity (PPP) theory make concerning the impact of domestic inflation on the home country's exchange rate? What are the limitations of the purchasing power parity theory?

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE: There are two versions of purchasing power parity theory. Absolute purchasing power parity states that a bundle of tradable products will have the same cost in different countries if this cost is stated in the same currency. Relative purchasing power parity states that the difference between changes over time in product price levels in two countries will be offset by the change in the exchange rate over this time. The exchange rate changes over time at a rate equal to the difference in the inflation rate of the two countries. Thus, the higher the inflation at home, the greater is the depreciation of the home currency against other currencies. The deviations from the parity occur more for the absolute version and in the short run. In addition, when measuring the average price level, countries may not use the same bundle of goods. Thus, the absolute parity relationship becomes more difficult to measure. There is more evidence to suggest that the relative version holds in the long run.