Exchange Rates: Purchasing Power Parity: Videos & Practice Problems

Purchasing Power Parity (PPP) is an economic theory that states exchange rates between two countries should adjust so that a given amount of money buys the same quantity of goods in both countries. For example, if \$1 equals 150 Japanese yen and a loaf of bread costs \$1 in the US and 150 yen in Japan, PPP holds because \$1 buys the same amount of bread in both countries. PPP helps explain how exchange rates equalize the purchasing power of different currencies, ensuring that goods have comparable prices internationally. It is a useful concept for understanding real exchange rates and how currency values reflect differences in price levels across countries.

Exchange rates can deviate from Purchasing Power Parity due to several factors. First, many goods and services are not traded internationally, such as restaurant meals, so their prices do not equalize across countries. Second, trade barriers like tariffs and import restrictions prevent prices from adjusting freely, causing deviations from PPP. Third, differences in consumer preferences and product quality can lead to price variations between countries. These factors mean that while exchange rates tend to move toward PPP over time, perfect equalization of purchasing power is often not achieved in practice.

A change in exchange rates affects the purchasing power of a currency by altering how much foreign goods and services can be bought with that currency. For example, if the exchange rate changes from \$1 = 150 yen to \$1 = 300 yen, the dollar has appreciated relative to the yen. This means \$1 can now buy twice as many yen, allowing you to purchase more goods priced in yen, such as two loaves of bread instead of one. Conversely, if the dollar depreciates, it buys fewer foreign goods. These changes impact international trade, consumption, and aggregate demand in an open economy.

Non-traded goods are products and services that cannot be easily bought or sold across borders, such as restaurant meals or haircuts. Because these goods are consumed locally and not subject to international competition, their prices are not influenced by exchange rates. This lack of price adjustment prevents Purchasing Power Parity from holding perfectly, as the cost of non-traded goods can vary significantly between countries. Therefore, non-traded goods contribute to deviations from PPP by creating price differences that exchange rates alone cannot equalize.

Trade barriers such as tariffs, quotas, and import restrictions limit the free flow of goods between countries. These barriers increase the cost of imported goods, preventing prices from equalizing internationally. As a result, exchange rates cannot fully adjust to equalize purchasing power across countries. Trade barriers create price distortions that cause deviations from Purchasing Power Parity, making it harder for currencies to reflect true differences in price levels and reducing the efficiency of international markets.