Purchasing Power Parity (PPP)
The purchasing power parity theory explains long term changes in the exchange rate. It explains that exchange rates are in equilibrium when their purchasing power is the same in each of the two countries. This means that differences in the purchasing power of two countries occur if the exchange rates differ. The theory predicts that if domestic inflation rises, e.g. by 5%, the exchange rate will fall by 5% thereby restoring the loss of competitiveness and enabling PPP to be reached. PPP is essentially the ‘law of one price’.
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