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.

How well does purchasing-power parity work when applied using Big Mac prices? Here are some examples from June 2005, when the price of a Big Mac was $3.06 in the United States.

You can see that the predicted and actual exchange rates are not exactly the same. After all, international arbitrage in Big Macs is not easy. Yet the two’ exchange rates are usually in the same ballpark. Purchasing power parity is not a precise theory of exchange rates, but it often provides a reasonable first approximation.

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