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  • Cited by 24
  • Print publication year: 2003
  • Online publication date: September 2012

3 - Purchasing power parity and the real exchange rate

Summary

The purchasing power parity (PPP) exchange rate is the exchange rate between two currencies which would equate the two relevant national price levels if expressed in a common currency at that rate, so that the purchasing power of a unit of one currency would be the same in both economies. This concept of PPP is often termed ‘absolute PPP’. ‘Relative PPP’ is said to hold when the rate of depreciation of one currency relative to another matches the difference in aggregate price inflation between the two countries concerned. If the nominal exchange rate is defined simply as the price of one currency in terms of another, then the real exchange rate is the nominal exchange rate adjusted for relative national price level differences. When PPP holds, the real exchange rate is a constant so that movements in the real exchange rate represent deviations from PPP. Hence, a discussion of the real exchange rate is tantamount to a discussion of PPP.

Although the term ‘purchasing power parity’ was coined as recently as eighty years ago (Cassel, 1918), it has a very much longer history in economics. While very few contemporary economists would hold that PPP holds continuously in the real world, ‘most instinctively believe in some variant of purchasing power parity as an anchor for long-run real exchange rates’ (Rogoff, 1996), and indeed the implication or assumption of much reasoning in international macroeconomics is that some form of PPP holds at least as a long-run relationship.

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