Purchasing power parity(PPP)?

Question

Explain why the PPP theory of exchange rate determination works better in the long run as opposed to the short run

Answer 1

The purchasing power parity (PPP) theory uses the long-term equilibrium exchange rate of two currencies to equalize their purchasing power. Developed by Gustav Cassel in 1920, it is based on the law of one price: the theory that, in an ideally efficient market, identical goods should have only one price.

A purchasing power parity exchange rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods. It is often used to compare the standards of living between countries, rather than a per-capita gross domestic product (GDP) comparison at market exchange rates. The best-known and most-used purchasing power parity exchange rate is the Geary-Khamis dollar (the "international dollar").

PPP exchange rates (the "real exchange rate") fluctuations are mostly due to market exchange rates movements. Aside from this volatility, consistent deviations of the market and PPP exchange rates are observed, for example (market exchange rate) prices of non-traded goods and services are usually lower where incomes are lower. (A U.S. dollar exchanged and spent in India will buy more haircuts than a dollar spent in the United States). PPP takes into account this lower cost of living and adjusts for it as though all income was spent locally. In other words, PPP is the amount of a certain basket of basic goods which can be bought in the given country with the money it produces.

There can be marked differences between PPP and market exchange rates. For example, the World Bank's World Development Indicators 2005 estimated that in 2003, one United States dollar was equivalent to about 1.8 Chinese yuan by purchasing power parity  Ã¢Â€Â” much different than the nominal exchange rate that put one dollar equal to 7.6 yuan. This discrepancy has large implications; for instance, GDP per capita in the People's Republic of China is about US$1,800 while on a PPP basis it is about US$7,204. This is frequently used to assert that China is the world's second-largest economy, but such a calculation would only be valid under the PPP theory. At the other extreme, Japan's nominal GDP per capita is around US$37,600, but its PPP figure is only US$30,615.