Abstract
The tendency for similar goods to sell for similar prices globally provides a link between prices and exchange rates. As prices change internationally, exchange rates must also change to keep the prices measured in a common currency equal across countries. In other words, exchange rates should adjust to offset differing inflation rates between countries. This relationship between the prices of goods and services and exchange rates is known as purchasing power parity (PPP). It is important to study the relationship between price levels and exchange rates in order to understand the role of goods markets (as distinct from financial asset markets) in international finance. This chapter explores this relationship through discussions of absolute purchasing power parity, relative purchasing power parity, the Big Mac index, and deviations from PPP. Also discussed is the relationship between time, inflation, and PPP. Real exchange rates are examined as compared to the nominal exchange rate. The chapter concludes with an appendix on the effect of relative price changes on PPP using a real-world example.
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