Purchasing power parity (PPP) is a coefficient of equivalence between currencies calculated on the basis of different price levels in each country. The purpose is to provide a reasonable comparison of the GDP of countries. PPP exchange rates may differ significantly from actual exchange rates. In the case of a balanced foreign trade, the exchange rate between two countries will tend to converge to the PPP. PPP is divided into absolute PPP and relative PPP. The former refers to the equilibrium exchange rate between the national currency and foreign currencies is equal to the ratio between the purchasing power of the national and foreign currencies or price level; the latter refers to the relative change between the purchasing power of the currencies of different countries is the determinant of exchange rate changes.
The theory of purchasing power parity (PPP) states that the exchange rate between the two countries will tend to converge to PPP in the case of foreign trade equilibrium. In general, this indicator is arrived at by examining many goods based on their importance relative to the economy. PPP is the ratio of the exchange rate between two currencies determined by their purchasing power per unit of currency. Purchasing power parity, which is also commonly referred to as the level of purchasing power.
Expanded:
Absolute Purchasing Power Parity (PPP) theory
1. Premise
The law of one price holds true for any tradable good; the various tradable goods are given equal weight in the compilation of price indices of the two countries.
2, the basic form
The relationship between the price levels of the two countries consisting of tradable goods: P = eP*
Deformed: e = P/P*
3, the meaning
It implies that the exchange rate depends on the ratio of the price levels of tradable goods measured in different currencies, that is, it depends on the ratio of purchasing power of different currencies over tradable goods. In modern analysis, it has been argued that there are various links between a country's non-tradable and tradable goods, and thus the law of one price holds for non-tradable goods as well.
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