S/E/13. A discussion of: the principle of Purchasing Power Parity : the relationship between exchange rates, prices and inflation

The principle of Purchasing Power Parity: the relationship between exchange rates, prices and inflation, originated as early as the 16th century. "While a few empirically literate economists take PPP seriously as a short-term proposition, most instinctively believe in some variant of PPP as an anchor for long-run real exchange rates." The first part of this section 2, will outline the economic theory behind the principle of PPP. The essence of this principle is that in equilibrium, no opportunity to make a profit or return will remain unexploited. Equilibrium will only exist when all profit-making opportunities have been exhausted. The latter part of this section will highlight the importance of PPP in the determination of monetary policy and the forecasting of exchange rates. The essay will analyse short run and long run models of the macro-economy. This will provide an explanation of deviation from PPP in the short-run, and convergence to it in the long run. The final part of this section will briefly discuss the evolution of econometric methods used to analyse the PPP doctrine.