Link of PPP with Real Exchange Rate (RER):

Purchasing Power Parity and Real Exchange Rate

It is possible to suggest an interpretation of PPP in terms of RER. The instantaneous response of the profit-seeking international arbitrageurs implies that net exports are extremely sensitive to small movements in the RER.

A slight drop in the prices of domestic goods relative to foreign goods — or, what comes to the same thing, a marginal fall in RER — induces arbitrageurs to buy goods in the home country (where prices are low) and sell them in foreign countries (where prices are high). The converse is also true.

A slight increase in the relative price of domestic goods induces arbitrageurs to import the same goods. This means that the net export schedule NX(e_r) is almost horizontal (completely elastic) at the RER that equalises purchasing power among the nations.

A slight drop in the RER leads to a substantial increase in net exports. This very fact ensures that the equilibrium RER is very close to the level ensuring purchasing power parity. This relation always holds.

Theory and Evidence of PPP:

The PPP is not very realistic the following two points may be noted in this context:

(i) Non-traded goods:

There are various non-traded goods and services such as haircuts. There is no scope of arbitrage even if prices differ across national borders. A barber from London cannot go to New York every now and then to earn more even if a haircut in New York is more expensive than in London.

(ii) Substitutability:

Furthermore, traded goods are relative prices of Rolls Royce and Ford cars can vary to some extent due to differences in tastes. This means that there is hardly any opportunity for making profits through arbitrage operations.

For these reasons, real exchange rates may and often do vary over time. However, the PPP doctrine provides a very important insight the fluctuations in the RER are very small and do not last for long. The reason is easy to find out the farther the RER deviates from the level predicted by purchasing power parity, the stronger is the incentive for individuals to engage in international arbitrage.

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