purchasing power parity

Definition

The theory that, in the long run, identical products and services in different countries should cost the same in different countries. This is based on the belief that exchange rates will adjust to eliminate the arbitrage opportunity of buying a product or service in one country and selling it in another. For example, consider a laptop computer that costs 1,500 Euros in Germany and an exchange rate of 2 Euros to 1 U.S. Dollar. If the same laptop cost 1,000 dollars in the United States, U.S. consumers would buy the laptop in Germany. If done on a large scale, the influx of U.S. dollars would drive up the price of the Euro, until it equalized at 1.5 Euros to 1 U.S. Dollar - the same ratio of the price of the laptop in Germany to the price of the laptop in the U.S. The theory only applies to tradable goods, not to immobile goods or local services. The theory also discounts several real world factors, such as transportation costs, tariffs and transaction costs. It also assumes there are competitive markets for the goods and services in both countries.

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purchasing power parity theory International Asset Pricing Model (IAPM)