Tuesday, June 27th 2017

Purchasing Power Parity - PPP


Purchasing Power Parity - PPP Meaning:
A theory which predicts that in the absence of limitations on free trade, a bundle of goods and services will cost the same in any two countries once exchange rates are taken into account. The rationale for this is that in the long run people will opt to exploit any differences by buying goods or services from (or in) the cheaper country, which in time will cause the prices to converge.

Purchasing Power Parity - PPP Example:
Suppose widgets cost US$2 in the United States and CAD$2 in Canada, with an exchange rate of US$1 = CAD$0.90. If there is a demand for them, one could expect people to travel across the border from the United States to Canada to buy their widgets, thereby saving money. In time, this would cause the value of the Canadian dollar to increase relative to the US dollar, prices for widgets in the United States to fall due to reduced demand, and prices for widgets in Canada to rise due to increased demand. The result would be converging prices until there is no advantage to be had in buying widgets from Canada.
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