LIMITATIONS OF PURCHASING POWER PARITY
Purchasing-power parity provides a simple model of how exchange rates are determined. For understanding many economic phenomena, the theory works well. In particular, it can explain many long term trends, such as the depreciation of the U.S. dollar against the German mark and the appreciation of the U.S. dollar against the Italian lira. It can also explain: the major changes in exchange rates that occur during hyperinflations.
Yet the. theory of purchasing-power parity is not completely accurate. That is, exchange rates do not always move to ensure that a dollar has the same real value in all countries all the time. There are two reasons the theory of purchasing-power parity does not always hold in practice . The first reason is that many goods are not easily traded. Imagine, for instance, that haircuts are more.
expensive in Paris than in New York. International travelers might avoid getting their haircuts in Paris, and some hair cutters might move from New York to Paris. Yet such arbitrage would be too limited to eliminate the differences in prices. Thus, the deviation from purchasing-power parity might persist, and a dollar (or euro) would continue to buy less of a haircut in Paris than in New York.
The second reason that purchasing-power parity does not always hold is that even tradable goods are not always perfect substitutes when they are produced in different countries. For example, some consumers prefer German cars, and others prefer American cars. Moreover, consumer tastes can change over time. If German cars suddenly become more popular, the increase in demand will drive up the price of German cars compared to American cars. But despite this difference in prices in the two markets, there might be no
opportunity for profitable arbitrage because consumers do not view the two cars as equivalent.
Thus, both because some goods are not tradable and because some tradable goods are not perfect substitutes with their foreign counterparts, purchasing-power parity is not a perfect theory of exchange-rate determination. For these reasons, real exchange rates fluctuate over time. Nonetheless, the theory of purchasing-power parity does provide a useful first step in understanding exchange rates. The basic logic is persuasive: As the real exchange rate drifts from the level predicted by purchasing-power parity, people have greater incentive to move goods across national borders. Even if the forces of purchasing-power parity do not completely fix the real exchange rate.