Why does ppp hold in the long run

Frenkel, J. Giovannini, A. Glen, J. Granger, C. Grilli, V. Haggan, V. Hakkio, C. Hansen, B. Heckscher, E. Hendry, D. Pagan and J. Grilliches and M. Intrilligator Eds. Huizinga, J. Husted, S. Johansen, S. Jorion, P.

Krugman, P. Kugler, P. Levin, A. Liu, H. Lo, A. Lothian, J. Lucas, R. MacDonald, R. Kaehler and P. Kugler Eds. XLIX, 11— Mark, N. Marston, R. Meese, R. Michael, P. Nobay and D. Mussa, M. Obstfeld, M. Oh, K-Y. However, the theory does imagine that traders eventually will adjust to the price differences buying low and selling high , causing an eventual adjustment of the spot exchange rate toward the PPP rate.

However, as adjustment occurs, it is quite possible that the PPP exchange rate also continues to change. In this case, the spot exchange rate is adjusting toward a moving target. How long will this adjustment take? In other words, how long is the long run? Also, since the target, the PPP exchange rate, is constantly changing, it is quite possible that it is never reached.

The adjustment process may never allow the exchange rate to catch up to the target even though it is constantly chasing it.

Perhaps the best way to see what the long-run PPP theory suggests is to consider Figure 6. The figure presents constructed data i. The dotted black line shows the ratio of the costs of market baskets between the two countries over a long period, a century between and It displays a steady increase, indicating that prices have risen faster in country A relative to country B.

The solid blue line shows a plot of the exchange rate between the two countries during the same period. If PPP were to hold at every point in time, then the exchange rate plot would lie directly on top of the market basket ratio plot. The fact that it does not means PPP did not hold all the time. In fact, PPP held only at times when the exchange rate plot crosses the market basket ratio plot; on the diagram this happened only twice during the century—not a very good record.

Nonetheless, despite performing poorly with respect to moment-by-moment PPP, the figure displays an obvious regularity. Sometimes the exchange rate is below the market basket ratio, even for a long period of time, but at other times, the exchange rate rises up above the market basket ratio.

The idea here is that lengthy exchange rate deviations from the market basket ratio i. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.

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Table of Contents Expand. Understanding RPPP. PPP in Theory. Dynamics of Relative PPP. Example of RPPP. Key Takeaways Relative purchasing power parity RPPP is an economic theory that states that exchange rates and inflation rates price levels in two countries should equal out over time. Compare Accounts.