Purchasing Power Parity (PPP) is an economic hypothesis for international trade. PPP relies on the assumption that there is free trade between countries, meaning that there are no barriers to trade (tariffs, import quotas, etc.). What PPP tells us is that there is a predictable relationship between product price levels and exchange rates, and in the long run, the relative prices of a certain good or service will be the same, after exchange rates are taken into account.

This equilibrium can be reached either by the prices within each country adjusting, or by the exchange rate between the two countries changing, or, most often, both. PPP can be used to describe how a nation's general price level must change to reestablish some desired exchange rate, given the level and trend in foreign prices.

There are some general tendencies that Purchasing Power Parity follows:
1. PPP predicts well at the level of one heavily traded commodity. PPP focuses on one particular product, which will eventually reach an equilibrium price in the world, fulfilling the "law of one price."
2. PPP predicts only moderately well at the level of all traded goods. PPP loses accuracy as we introduce more and more goods. There are many technical difficulties with comparing index numbers of different products, especially when we add those that inevitably will have differing prices in different countries. Examples of this could be those products having significant transport costs or technology differences.
3. PPP predicts least well at the level of all products in the economy. PPP cannot account for nontraded products in the economy, thus cannot be a good predictor for nation's GDPs or price indices for products that account for GDP.
4. PPP predicts better over the long run than the short run.
5. PPP implies that countries with relatively low inflation rates have currencies whose values tend to appreciate in the foreign exchange market. The opposite is also true.

The equation for PPP looks somewhat like this:
rs = P/Pf
where rs is the exchange rate between two countries and P and Pf are product prices levels in the home country and foreign country, respectively.

For those of you who made it through this without falling asleep, I congratulate you. I recommend applying to NYU's Stern School of Business.

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