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

Purchasing Power Parity - Essay ExampleIt states that the untaught which is having high inflation rate is weak in terms of currency because inflation reduces the real purchasing power of a nations currency. It predicts a relationship between the inflation rates of ii countries over a specified period and the sweat in the shift 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 set 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 hoop of commodities or individual commodities. The relative PPP approximates the change in indiv idual price by change in price indices. observational 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 imitation that the cost of orange is same worldwide. Empirical evidence of relative PPP Japans 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. Thats 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.