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The exchange rate that equalizes the prices of internationally traded goods across countries is called the purchasing power parity (PPP)    exchange rate. A group of economists at the International Comparison Program, run by the World Bank, have calculated the PPP exchange rate for all countries, based on detailed studies of the prices and quantities of internationally tradable goods.

The purchasing power parity exchange rate has two functions. First, PPP exchange rates are often used for international comparison of GDP and other economic statistics. Imagine that you are preparing a table showing the size of GDP in many countries in several recent years, and for ease of comparison, you are converting all the values into U.S. dollars. When you insert the value for Japan, you need to use a yen/dollar exchange rate. But should you use the market exchange rate or the PPP exchange rate? Market exchange rates bounce around. In summer 2008, the exchange rate was 108 yen/dollar, but in late 2009 the U.S. dollar exchange rate versus the yen was 90 yen/dollar. For simplicity, say that Japan’s GDP was ¥500 trillion in both 2008 and 2009. If you use the market exchange rates, then Japan’s GDP will be $4.6 trillion in 2008 (that is, ¥500 trillion /(¥108/dollar)) and $5.5 trillion in 2009 (that is, ¥500 trillion /(¥90/dollar)).

Of course, it is not true that Japan’s economy increased enormously in 2009—in fact, Japan had a recession like much of the rest of the world. The misleading appearance of a booming Japanese economy occurs only because we used the market exchange rate, which often has short-run rises and falls. However, PPP exchange rates stay fairly constant and change only modestly, if at all, from year to year.

The second function of PPP is that exchanges rates will often get closer and closer to it as time passes. It is true that in the short run and medium run, as exchange rates adjust to relative inflation rates, rates of return, and to expectations about how interest rates and inflation will shift, the exchange rates will often move away from the PPP exchange rate for a time. But, knowing the PPP will allow you to track and predict exchange rate relationships.

Key concepts and summary

In the extreme short run, ranging from a few minutes to a few weeks, exchange rates are influenced by speculators who are trying to invest in currencies that will grow stronger, and to sell currencies that will grow weaker. Such speculation can create a self-fulfilling prophecy, at least for a time, where an expected appreciation leads to a stronger currency and vice versa. In the relatively short run, exchange rate markets are influenced by differences in rates of return. Countries with relatively high real rates of return (for example, high interest rates) will tend to experience stronger currencies as they attract money from abroad, while countries with relatively low rates of return will tend to experience weaker exchange rates as investors convert to other currencies.

In the medium run of a few months or a few years, exchange rate markets are influenced by inflation rates. Countries with relatively high inflation will tend to experience less demand for their currency than countries with lower inflation, and thus currency depreciation. Over long periods of many years, exchange rates tend to adjust toward the purchasing power parity (PPP) rate, which is the exchange rate such that the prices of internationally tradable goods in different countries, when converted at the PPP exchange rate to a common currency, are similar in all economies.

Questions & Answers

it is the relatively stable flow of income
Chidubem Reply
what is circular flow of income
Divine Reply
branches of macroeconomics
SHEDRACK Reply
what is Flexible exchang rate?
poudel Reply
is gdp a reliable measurement of wealth
Atega Reply
introduction to econometrics
Husseini Reply
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Tom
Why is unemployment rate never zero at full employment?
Priyanka Reply
bcoz of existence of frictional unemployment in our economy.
Umashankar
what is flexible exchang rate?
poudel
due to existence of the pple with disabilities
Abdulraufu
the demand of a good rises, causing the demand for another good to fall
Rushawn Reply
is it possible to leave every good at the same level
Joseph
I don't think so. because check it, if the demand for chicken increases, people will no longer consume fish like they used to causing a fall in the demand for fish
Anuolu
is not really possible to let the value of a goods to be same at the same time.....
Salome
Suppose the inflation rate is 6%, does it mean that all the goods you purchase will cost 6% more than previous year? Provide with reasoning.
Geetha Reply
Not necessarily. To measure the inflation rate economists normally use an averaged price index of a basket of certain goods. So if you purchase goods included in the basket, you will notice that you pay 6% more, otherwise not necessarily.
Waeth
discus major problems of macroeconomics
Alii Reply
what is the problem of macroeconomics
Yoal
Economic growth Stable prices and low unemployment
Ephraim
explain inflationcause and itis degre
Miresa Reply
what is inflation
Getu
increase in general price levels
WEETO
Good day How do I calculate this question: C= 100+5yd G= 2000 T= 2000 I(planned)=200. Suppose the actual output is 3000. What is the level of planned expenditures at this level of output?
Chisomo Reply
how to calculate actual output?
Chisomo
how to calculate the equilibrium income
Beshir
Criteria for determining money supply
Thapase Reply
who we can define macroeconomics in one line
Muhammad
Aggregate demand
Mohammed
C=k100 +9y and i=k50.calculate the equilibrium level of output
Mercy Reply
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money as unit of account means what?
Kalombe
A unit of account is something that can be used to value goods and services and make calculations
Jim
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Muhammad
I want to know how can we define macroeconomics in one line
Muhammad
it must be .9 or 0.9 no Mpc is greater than 1 Y=100+.9Y+50 Y-.9Y=150 0.1Y/0.1=150/0.1 Y=1500
Kalombe
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Kalombe
hi can someone help me on this question If a negative shocks shifts the IS curve to the left, what type of policy do you suggest so as to stabilize the level of output? discuss your answer using appropriate graph.
Galge Reply
if interest rate is increased this will will reduce the level of income shifting the curve to the left ◀️
Kalombe

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Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
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