Which of the following is NOT correct about the law of one price and the purchasing power parity (PPP) theory?

Question

BlackTom AI · Accepted Answer

To tackle the question, I’ll assess each statement in light of the law of one price and purchasing power parity (PPP) theory.
Option 1: 'The PPP theory requires the assumption that trade in goods and services is free of transportation costs and trade barriers.' This is generally true. PPP relies on the idea that identical goods should sell for the same price when expressed in a common currency, which presumes no transport costs or barriers that would create price differences. In reality, transportation costs and trade barriers can cause deviations, but the foundational PPP formulation does assume their absence or at least negligible impact for the theory to hold.
Option 2: 'The PPP theory provides reasonably accurate predictions regarding the long-term movement of exchange rates.' This is a nuanced claim. PPP is often described as a long-run concept, suggesting that exchange rates should move to equalize price levels across countries. However, empirical evidence shows PPP can be a poor predictor for short- to medium-term movements and may not be highly accurate even in the long run due to factors like monetary policy, capital flows, and price stickiness. Therefore, saying it provides reasonably accurate predictions for long-run movements is not universally accepted and is commonly viewed as overstating PPP’s predictive power.
Option 3: 'The PPP theory will hold if similar goods across countries are very good substitutes.' This aligns with PPP logic. If goods are highly substitutable across borders, price arbitrage is more effective, and the law of one price is more likely to hold, supporting PPP in the long run. Thus, this statement is consistent with PPP assumptions.
Option 4: 'The law of one price suggests that identical products sold in different countries should carry the same price once those prices are expressed in local currencies.' This wording is subtly misleading. The law of one price states that identical goods should have the same price when expressed in a common currency, assuming no transportation costs or trade frictions. Expressing prices in local currencies does not yield identical prices due to exchange rate differences; you need a common currency to compare prices directly. Hence, this statement is not accurate as written, because it omits the need for a common currency for price parity to hold conceptually.

Which of the following is NOT correct about the law of one price and the purchasing power parity (PPP) theory? Single choice

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________ states that differential rates of inflation between two countries tend to be offset over time by an equal but opposite change in the spot exchange rate.

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