Application of PPP in the Short Run
Purchasing Power Parity (PPP) is a theory that asserts that residents in a single country in the globe should be in a position to buy good in the same price as residents of s different country…
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International trade has then been seen to lead to an equalization of purchasing power which economist describe as parity. However, this theory has been seen to have many shortcomings (Wallace, 2007: 34). For instances, the prices of different goods cannot be the same in all countries. This is because there are barriers to trade which lead to the prices increasing gradually as they pass from one country to the next. These include the tariffs, taxes and shipment costs. For instance, a car in America may cost only $5000 but when it is shipped a country such as South Africa, its final cost is $2000 higher than the price it is sold at in America. Other commodities of trade because of their nature cannot be imported to another country. These include services such giving haircuts or other products such as real estate. Moreover, a person in a rural village in Brazil may not have the luxury of choosing different goods or services on the international market and may just end up buying good on the prices offered in their country. Moreover, not all types of goods and services have demand in every country. For instance, America may not have a specific price for a rice harvester because it does not grow rice. The price of a rice harvester would thus only be determined by the countries which have a demand for it such as Vietnam. The cost of living in different countries is different and this definitely affects their purchasing power. For instance, the cost of living in China is way low compared to the cost of living in America (Ullrich, 2009: 78). China applies the strategy of reducing the cost of living in her country so that it can pay her workers lower wages reducing the production cost. This makes her exports cheaper compared to that of other players in the global market giving it a competitive edge. In some instances, PPP has been used to position the exchange rates of new countries or even predict expectations on future exchange rates. There are two versions of PPP that have been used by economist all over the globe. These are relative and absolute PPP. Absolute PPP is the equalization of good’s prices in different countries. Relative PPP on the other hand asserts that the change of exchange rates over time between different countries is relative to the change in prices of standards goods in these countries (Obstfeld &Taylor, 2004: 318).PPP has been seen to prove to hold true in its assumptions in the long run. This is because as a result of removal of trade barriers and enhancement of free trade in the globe, the price of standard goods without the inclusion of costs such as shipment costs, tariffs and taxes is similar around the globe. It would take years for prices of products to be equalized in the globe. However, various economists have argued that PPP do not hold true in the short run. This is because the exchange rates are controlled by the news in the short run. News regarding change in the perceptions of the development of exchange rates in the future has an immediate effect on the current exchange rate. The rates are also influenced by other announcement such as interest rate changes. This paper studies PPP and exchange rates in EU and US to show how PPP cannot hold in the short-term. In the developing countries, PPP is measures using a comparison of the official
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Short-run Phillips curve & the long-run Phillips curve
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due to various market frictions” (Dwyer, Fisher, Flavin & Lothian, 2005); PPP fails to hold more in short run than in long run (Amara & Murphy, 2005; Anorou, Braha & Ahmad, 2002; Culver & Papell, 1999; Caetano, Moura & Da Silva, 2004; DEUTSCHE BUNDESBANK, June 2004); “there