In this essay I will analyze the theory of Purchasing Power Parity and discuss its applicability. I will begin by explaining the basic concepts of PPP. In order to get a deeper understanding of the theory I will also briefly touch on topics such as the Law of One Price, the Big Mac index and similar subjects related to the Purchasing Power Parity theory. Furthermore the PPP theory will be put in to practice and its applicability will be discussed and evaluated using real life examples.
It is necessary to understand the functions of the PPP theory before giving a definition to it. The purchasing power parity theory is a measurement that is being used within the economy to compare the currencies of different countries and to see if their currencies are under or over valuated. It is also commonly used as a measurement to compare the living standard between two countries.
The Purchasing Power Parity theory is developed on the basis of the law of one price
(LOP). The law states that once converted to a common currency, the same good should sell for the same price in different countries. (Kalinda Mkenda, 2001)
To give an example of this lets neglect all the factors such as taxes, tariffs and transportations costs. The law of one price can then be explained with the following formula:
e = PSWE/PUK
where e equals the nominal exchange rate and P price.
If I buy a bike in Sweden for 1000:- this means the same bike should, in theory cost £100 to buy in UK which gives us a nominal exchange rate of 10. If a bike would sell for any price higher in UK, there would be a clear advantage for consumers to go to Sweden to buy bikes (remember that factors such as travelling costs are neglected in this example). Also, it would be beneficial for traders to go to Sweden and buy bikes and sell them in UK for a profit, also called arbitrage. However, this kind of activity would slowly drive prices... [continues]
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