Your Textbook And The Unit Lesson Discuss Both Versions
Your Textbook And The Unit Lesson Discuss The Two Versions Of Purchasi
Your textbook and the unit lesson discuss the two versions of purchasing power parity (PPP). They are absolute PPP and relative PPP. If a domestic government entity released economic information that suggested that the purchasing power of money in the future will be less than previously expected, what would happen to the current exchange rate today? Will both absolute PPP and relative PPP hold, or will only one of them hold? Support your answer, and analyze the responses of your peers.
Paper For Above instruction
The scenario described involves a domestic government releasing economic information indicating a future decrease in the purchasing power of its currency. This anticipated decline in future purchasing power has immediate implications for the current exchange rate and the applicability of the two dominant PPP theories: absolute PPP and relative PPP.
Impact on the Current Exchange Rate
A forecast that future purchasing power will decline typically influences expectations about the currency's value. Investors, traders, and economic agents often act based on predictions about future conditions, which influence current exchange rates through mechanisms such as speculative trading and adjustment expectations. If economic news suggests that inflation (a key factor reducing purchasing power) is likely to accelerate, then the currency is expected to depreciate in the future. To reflect this expectation, the current exchange rate would tend to depreciate. This is because market participants anticipate that, in the future, the domestic currency will lose value relative to foreign currencies, prompting a sell-off of domestic currency holdings now to avoid losses, thereby decreasing the current exchange rate's value in terms of foreign currency.
Applicability of Absolute and Relative PPP
Absolute PPP posits that the exchange rate between two currencies should equal the ratio of the price levels in the two countries, implying a long-term equilibrium where identical goods cost the same across borders once adjusted for exchange rate differences. Under absolute PPP, the current exchange rate would adjust immediately to reflect changes in price levels; if domestic prices are expected to rise relative to foreign prices, the exchange rate should depreciate to restore parity, assuming perfect market conditions.
In contrast, relative PPP focuses on the rate of change of price levels and exchange rates over time, suggesting that the expected inflation differential between two countries determines future changes in exchange rates. Specifically, if the domestic country is expected to experience higher inflation than its trading partners, the currency should depreciate proportionally over time. Immediate short-term deviations are common, but the theory holds in a long-term equilibrium perspective.
Given the economic information indicating a future decline in purchasing power due to rising inflation, relative PPP would imply that the current exchange rate should start adjusting immediately to account for the anticipated inflation differential. This means that, today, the exchange rate should begin to depreciate ahead of the actual decrease in purchasing power, aligning with the market's expectations based on relative PPP.
Which Theory Holds?
In practice, absolute PPP rarely holds in the short term because of market imperfections, transaction costs, and other frictions. However, for the long term, absolute PPP often provides a reasonable approximation. Relative PPP tends to be more applicable in explaining how exchange rates change over periods where inflation differentials are expected to influence the rates.
In the current scenario, since the economic information suggests an upcoming decline in purchasing power, only relative PPP is likely to hold as an immediate guiding framework. Absolute PPP would not necessarily hold immediately because market adjustments take time, and prices in goods and services may not adjust instantaneously. However, over the longer term, as inflation differentials materialize, both theories would align, with relative PPP explaining the adjustments and absolute PPP reflecting a re-equilibration based on price levels.
Conclusion and Peer Analysis
In conclusion, the release of economic information indicating future decreases in purchasing power leads to an expectation of currency depreciation in the present. This aligns more closely with the principles of relative PPP, which emphasizes the importance of expected inflation rates in influencing exchange rates over time. Absolute PPP, while useful in theory, is less likely to immediately hold due to market imperfections and price stickiness. When analyzing peers’ responses, it is essential to consider differing economic contexts, including whether they focus on short-term market reactions versus long-term trends, and to acknowledge the limitations and assumptions of each PPP theory.
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