In an international and globalize environment such as the national economies are growing in, it is hard to measure and evaluate the performances of each one in comparison with the others. Indeed, currencies are different all around the world and to what we can or cannot afford or in a foreign country with our national currency, we need to measure the purchasing power between a national currency and a foreign currency. Some economists have tried to build two principal tools to compare two economies performances. The first one takes in account and compares the nominal exchange rates on the exchange market between two different currencies. This method is the simplest one and gives an approximation of the real performances of two economies. Empirically, this method has shown a lot of limits and inaccurate results, which takes us to the second method. This one makes a comparison of the purchasing power that a home currency offers in a foreign currency. This tool is called the Purchasing Power Parity.
[...] The empirical limits of purchasing power parity methods In opposition to the of one price”, we cannot deny that in reality, transport costs exist and are combined with trade costs and trade barriers. Indeed, they make the exchange flows more expensive and change the trade flows, which threatens the of one price” brought by Ricardo. These additional costs break the close relationship between the level of prices and the exchange rates. In fact, the bigger the transport costs are, the bigger the gap where the exchange rate can vary is. [...]
[...] It can be logged as: log = log log(Pf) = This equation compares the nominal depreciation rate and the inflation rate difference. In this method, the real exchange rate has to be equal to the unit. Q can be logged as: Q = S. Pf/Ph log = log(S) + log log(Ph) To be verified, following this equation, log has to be equal to 0 and then that the real exchange rate has to be equal to the unit. Which means that the real exchange rate holds (which is quasi-impossible). [...]
[...] This is another threat against the relative PPP method. Purchasing power parity can have bad performances in accordance with its limits; and these ones can lead to strong divergences in the general price level forecasted by the PPP method. Conclusion The PPP can be analyzed in short-term and long-term perspective. Indeed, if the price of goods holds or changes but not immediately, the divergence between the levels of price predicted by the PPP method is more important in a shot term perspective than in a long term perspective. [...]
[...] However this mechanism takes time, and the European and international level of price of goods can be different until the law of markets comes to rebalance this unbalance of exchange rate. The exchange rates volatility and the prices rigidity can help to explain this phenomenon. Therefore, in a short-term perspective, we can emphasize that these divergences are bigger when the exchange rates are changing fast. However, the facts show that these divergences are less obvious after one year. To sum-up and conclude, PPP methods in a short-term perspective are less relevant than in a long-term view because of the time that the adjustments in the markets take to perform. [...]
[...] On the other hand, when an enterprise trades the same goods but at different prices in different markets, depending on the demand price- elasticity of each market, it makes the link between prices and exchange rates weaker. Thus, the behaviour of, “pricing to market” implies that there are several types of demand for several types of markets, but for the same good. For example, buying a Fiat Punto in Finland is less expensive for a German inhabitant rather than buying the same car in Germany even if they share the same currency (following the PricewaterhouseCoopers and eurocarprice.com index of the new car market in 19 European countries). [...]
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