• Purchasing-power parity is a theory of exchange rates whereby a unit of any

given currency should be able to buy the same quantity of goods in all
countries. The theory of purchasing-power parity is based on a principle
called the law of one price. This law asserts that a good must sell for the
same price in all locations. Otherwise, there would be opportunities for
profit left unexploited. More clearly, Parity means equality, and purchasing
power refers to the value of money in terms of the quantity of goods it can
buy. Purchasing-power parity states that a unit of a currency must have the
same real value in every country. Furthermore, tt can explain many long-
term trends, such as the depreciation of the U.S. dollar against the German
mark and the appreciation of the U.S. dollar against the Italian lira. It can
also explain the major changes in exchange rates that
occurduringhyperinflations.

The theory of purchasing-power parity is not completely accurate. That is

exchange rates do not always move to ensure that a dollar has the same real
value in all countries all the time. There are limitations theory of purchasing-
power parity does not always hold in practice. One of the reason is that
many goods are not easily traded or shipped from one country to another.
For instance, we assume that haircuts are more expensive in Paris than in
New York. International travelers might avoid getting their haircuts in Paris,
and some haircutters might move from New York to Paris. Yet such arbitrage
would be too limited to eliminate the differences in prices. Thus, the
deviation from purchasing-power parity might persist, and a dollar (or euro)
would continue to buy less of a haircut in Paris than in New York. Thus
purchasing power parity is not a perfect theory of exchange rate
determination.