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Exchange Rates: Purchasing Power Parity quiz

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  • What does purchasing power parity (PPP) mean in the context of exchange rates?
    PPP means exchange rates equalize the purchasing power of currencies, so a unit of currency buys the same amount of goods in different countries.
  • How can you tell if PPP holds using the price of bread in the US and Japan?
    If \$1 buys one loaf of bread in the US and, after converting to yen, also buys one loaf in Japan, PPP holds.
  • What happens to PPP if the exchange rate changes from \(1 = 150 yen to \)1 = 300 yen, but bread prices stay the same?
    PPP does not hold because \$1 now buys two loaves of bread in Japan but only one in the US.
  • What is the effect of exchange rate fluctuations on PPP?
    Exchange rate fluctuations can cause PPP to be violated if the purchasing power of a currency differs across countries.
  • Why do non-traded goods prevent PPP from holding perfectly?
    Non-traded goods, like restaurant meals, are not exchanged internationally, so their prices are not equalized by exchange rates.
  • How do trade barriers affect PPP?
    Trade barriers such as tariffs or import restrictions prevent prices from equalizing across countries, disrupting PPP.
  • What role do differing preferences play in PPP?
    If preferences for a product are higher in one country, its price may be higher there, preventing PPP.
  • What is the expected general trend for prices across countries according to PPP?
    Prices are expected to normalize across countries unless barriers like non-traded goods or trade restrictions prevent PPP.
  • How does PPP relate to real exchange rates?
    PPP helps analyze real exchange rates by comparing the purchasing power of currencies for a given basket of goods.
  • What is the impact of currency appreciation or depreciation on PPP?
    Appreciation or depreciation can cause PPP to be violated if the currency's purchasing power changes unevenly across countries.
  • How does PPP affect aggregate demand in an open economy?
    PPP influences aggregate demand by affecting the relative prices of goods and services internationally.
  • What is the relationship between PPP and trade balances?
    PPP affects trade balances by influencing the competitiveness of domestic versus foreign goods.
  • Why might restaurant prices differ between the US and Europe despite exchange rates?
    Restaurant meals are non-traded goods, so their prices are not equalized by exchange rates, leading to differences.
  • What is an example of a situation where PPP does not hold?
    If \$1 buys one loaf of bread in the US but two loaves in Japan after currency conversion, PPP does not hold.
  • What factors can prevent PPP from being achieved in practice?
    Non-traded goods, trade barriers, and differing preferences can prevent PPP from being achieved.