Questions: Absolute Purchasing Power Parity

Question 1

A Big Mac costs $5.58 in the US and ¥700 in Japan. Absolute PPP implies the exchange rate should be 125 yen per dollar. The actual rate is 150 yen per dollar. What does this suggest?

• A. The yen is overvalued relative to PPP because it buys fewer dollars than PPP predicts
• B. The yen is undervalued relative to PPP because more yen are needed per dollar than PPP predicts
• C. The dollar is undervalued because the yen buys more Big Macs per dollar than PPP suggests
• D. The deviation is meaningless since absolute PPP never holds in practice

Answer: (B)

PPP predicts 125 yen/dollar, but the actual rate is 150 yen/dollar — you need MORE yen than PPP predicts to buy one dollar. This means the yen is UNDERVALUED relative to PPP: the yen has less purchasing power in dollar terms than the goods-price comparison would suggest. Option A confuses direction: an overvalued yen would mean fewer yen are needed per dollar than PPP predicts, not more.

Question 2

Absolute PPP fails to hold precisely in the short run primarily because of which mechanism?

• A. Central banks actively prevent exchange rate movements toward PPP
• B. Non-traded goods like haircuts and housing cannot be arbitraged across borders, allowing persistent price differences
• C. Goods arbitrage is too fast — exchange rates overshoot PPP and then oscillate
• D. PPP only applies to developing economies, not advanced economies with flexible exchange rates

Answer: (B)

The key reason absolute PPP fails, especially in the short run, is non-traded goods: services and goods that cannot be physically moved across borders can maintain price differences indefinitely. Countries with low labor costs can sustain systematically lower prices for these services — the Balassa-Samuelson effect. Option B has it backwards — goods arbitrage in reality is SLOW because of trade barriers and transportation costs. Exchange rate overshooting (Option C) is a real phenomenon but is about short-run dynamics, not the reason for persistent long-run deviations.

Question 3

Absolute PPP in its strict form applies mainly to traded goods; it explicitly excludes services and non-traded goods from the price basket.

• T. True
• F. False

Answer: False

Absolute PPP in its strict form applies to a basket of ALL goods, including both traded and non-traded goods. However, it is precisely because non-traded goods are included that PPP fails in practice — non-traded goods cannot be arbitraged, so their prices can diverge across countries without triggering the exchange rate adjustment that the theory predicts. The existence of non-traded goods is a reason why PPP holds poorly, not a feature of its definition.

Question 4

Absolute PPP is more useful as a long-run benchmark for assessing currency misalignment than as a short-run exchange rate forecasting tool.

• T. True
• F. False

Answer: True

Empirically, exchange rates show some tendency to revert toward PPP over long horizons (5–10+ years), with half-life deviations of roughly 3–5 years. In the short run, capital flows, monetary policy expectations, and risk sentiment overwhelm goods-market arbitrage, making PPP nearly useless for forecasting next month's spot rate. This is why economists use PPP exchange rates to compare GDP across countries (a structural benchmark question) rather than to predict short-run exchange rate movements.

Question 5

Explain why absolute PPP is based on a goods arbitrage argument, and identify the main reasons why this arbitrage is imperfect in practice.

Model answer: Absolute PPP rests on the law of one price applied to a basket of goods: if identical goods cost different amounts in two countries when expressed in a common currency, arbitrageurs can buy in the cheap country and sell in the expensive one, earning a profit while simultaneously driving the cheap-country price up, the expensive-country price down, and the exchange rate toward the PPP value. In practice, this arbitrage is imperfect for three reasons: (1) non-traded goods (services, real estate) cannot be physically moved, so price gaps persist indefinitely; (2) trade barriers, tariffs, and transportation costs create a band around PPP within which arbitrage is unprofitable; (3) short-run exchange rate dynamics are dominated by capital flows and monetary factors that can overwhelm goods-market adjustment for years.

The Balassa-Samuelson effect is a systematic consequence of non-traded goods: richer countries have higher productivity in traded goods, which bids up wages across the economy, raising non-traded goods prices — making richer countries systematically more expensive than PPP based on traded goods alone would predict.