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What is the implication for the real exchange rate if the PPP condition holds?

Under what circumstances does the PPP theory explain how exchange rates are determined.

why is it not completely accurate all the time?

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Anne Gillian Duero
Anne Gillian DueroLv10
28 Sep 2019

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Related questions

Answer the following questions related to the predictions of PPP:

(a) What are the predictions of the PPP theory regarding real exchange rates?

(b) Discuss why the empirical support for PPP and the law of one price is weak in recent data.

Large-scale wars typically bring a suspension of international trading and financial activities. Exchange rates lose much of their relevance under these conditions, but once the war is over, governments wishing to fix exchange rates face the problem of deciding what the new rates should be. The PPP theory has often been applied to this problem of postwar exchange rate realignment. Imagine that you are a British Chancellor of the Exchequer and that World War I has just ended. Explain how you would figure out the dollar/pound exchange rate implied by PPP. When might it be a bad idea to use the PPP theory in this way?

In the long run, exchange rates reflect purchasing power parity (PPP). This theory called the law of one price, aggregates and generalizes the idea that the same good must sell for the same price, in the same currency units, regardless of where it is produced. The following questions consider how PPP and the law of one price work and whether they can explain long-run exchange rate movements.

PPP may not hold because:

A. The law of one price applies, on average, to all goods.

B. Countries are gradually reducing trade restrictions.

C. All goods and services can trade at a relatively low cost.

D. Goods produced in different countries vary greatly in quality.

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