ABSTRACT
Theories of exchange rate determination have relied on the idea that currency parities are greatly affected by nations’ price levels, especially in the long run. This idea is known as the purchasing power parity theory (PPP). This chapter explains how anticipations about the future relationship between domestic and foreign prices, or the ratio of domestic to foreign inflation, create expectations regarding the future of the exchange rate. Absolute PPP is based on the law of one price. This law states that in a competitive market, identical goods sold in different countries must sell for the same price when the prices of the two or more goods are expressed in terms of the same currency. When using PPP as a measure of the long-term relationship between two currencies, it is worth keeping in mind the following considerations. First, it is necessary to carefully select the base period. Second, it is important to select the appropriate price indices.
