Purchasing Power Parity Effects

Purchasing Power Parity Effects

What is the theory of purchasing power parity? Does the theory successfully explain all long-run exchange rate movements? What are some reasons that it might not always explain such movements? How does the PPP impact customers and businesses differently?
You decide to work in Japan for the next ten years, accumulate some savings, then move back to the United States and convert your savings from yen to dollars. At the time of your move, economists predict that consumers in the United States have reignited their love of Japanese products, especially hoverboards and 3D televisions, and expect this strong preference for Japanese products will continue for the next decade. Should these predictions encourage or discourage you from working and saving in Japan Why Should you reconsider your move and/or reconsider it in the future?

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Purchasing Power Parity Effects

The theory of purchasing power parity (PPP) posits that, in the long run, the exchange rate between two countries’ currencies should adjust to equalize the price of a basket of goods and services in both countries. Essentially, the same goods should cost the same in two different countries when expressed in a common currency. This principle is based on the Law of One Price, which assumes no transportation costs or trade barriers.

Mathematically, PPP can be expressed as:

$\frac{P_{\text{foreign}}}{P_{\text{domestic}}}$

Where:

$E$ = nominal exchange rate (units of foreign currency per domestic currency)
$PforeignP_{\text{foreign}}$ = price level in the foreign country
$PdomesticP_{\text{domestic}}$ = price level in the domestic country

Does the theory successfully explain all long-run exchange rate movements?

No, the PPP theory does not fully explain all long-run exchange rate movements, even though it provides a general framework. While PPP is useful in identifying long-term trends, actual exchange rates often deviate due to