What is purchasing power parity (PPP) and when does it fail?

What is purchasing power parity (PPP) and when does it fail?

• A. PPP theory states exchange rates are fixed by governments.
• B. PPP holds in all circumstances.
• C. PPP means exchange rates never adjust.
• D. PPP is the idea that exchange rates adjust to equalize price levels; it fails due to non-tradable goods, transportation costs, and barriers.

Answer: (D)

Purchasing power parity is the idea that exchange rates move so that a standard basket of goods costs the same in every country when priced in the same currency. In other words, currencies should adjust to equalize price levels across borders. This tends to hold in theory only when goods are tradable and costs of getting them to market are negligible. In the real world, PPP fails because many things are non-tradable—think housing, locally served services, and other items that can’t easily cross borders. Even for tradable goods, transportation costs, insurance, tariffs, and other barriers create price differences between countries. These frictions prevent a perfect price-level equalization, so exchange rates don’t always move to exactly balance prices. So the best description is that PPP posits exchange rates adjust to equalize price levels, but it fails due to non-tradable goods, transportation costs, and barriers that keep price levels from aligning perfectly.

Purchasing power parity is the idea that exchange rates move so that a standard basket of goods costs the same in every country when priced in the same currency. In other words, currencies should adjust to equalize price levels across borders.

This tends to hold in theory only when goods are tradable and costs of getting them to market are negligible. In the real world, PPP fails because many things are non-tradable—think housing, locally served services, and other items that can’t easily cross borders. Even for tradable goods, transportation costs, insurance, tariffs, and other barriers create price differences between countries. These frictions prevent a perfect price-level equalization, so exchange rates don’t always move to exactly balance prices.

So the best description is that PPP posits exchange rates adjust to equalize price levels, but it fails due to non-tradable goods, transportation costs, and barriers that keep price levels from aligning perfectly.