土豆妮

Harold Jennings, CFA, an economist the World Bank, is considering the use of purchasing power parity (PPP) as a useful tool in forecasting exchange rates for certain South American countries. The appropriate method he should use is:

A) relative PPP because it tends to hold over the short run.

B) absolute PPP because it tends to hold over the long run.

C) relative PPP because it tends to hold over the long run.

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Although evidence tends to suggest that PPP does not hold in the short run, empirical evidence suggests that relative PPP does tend to hold more closely over the longer term. Currencies that become overvalued or undervalued in relation to PPP over time tend to eventually revert back to the long-term level predicted by relative PPP. That means relative PPP is somewhat useful in exchange rate determination in the short run because currencies that are overvalued relative to their PPP-determined fundamental value will tend to depreciate, while undervalued currencies will tend to appreciate. However, the adjustment period can sometimes be quite long (i.e., several years). Note that absolute PPP is of little use In determining exchange rates because we would need to have identical individual goods and services to establish validity, and goods consumed are rarely identical between various countries.

土豆妮

Carole Holden, CFA, is an economist for the International Monetary Fund. As a believer of purchasing power parity (PPP), she wants to create a suitable basket of goods for use in all countries as a means of determining exchange rates. Although she is very idealistic in her endeavor, one major shortcoming in her approach is that absolute PPP assumes:

A) real interest rates are constant throughout the world.

B) there are no restraints to trade.

C) inflation rates are constant throughout the world.

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Absolute PPP is of little use in determining exchange rates. In order to directly compare the prices of goods and services between two countries, identical individual goods and services are necessary to establish the validity of the law of one price. However, goods are rarely identical between various countries. In reality, restraints to trade, including differences in taxes, transportation and labor costs, rents, and government controls (e.g., tariffs) provide complexities that prevent direct comparison. Therefore, it is difficult (if not impossible) to confirm whether exchange rates are under- or overvalued according to absolute PPP.

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