Critically examine the purchasing power parity theory?

Question: Critically examine the purchasing power parity theory?

The purchasing power parity (PPP) theory, which suggests that exchange rates should adjust to equalize the purchasing power of different currencies, has been subject to critical examination. Critics argue that the theory overlooks various factors that influence exchange rates, such as trade barriers, transportation costs, and non-tradable goods. Moreover, PPP assumes perfect market conditions, which rarely exist in reality. Additionally, the theory fails to account for differences in quality and availability of goods and services, as well as individual consumption preferences across countries. While PPP provides a theoretical framework, its limitations necessitate consideration of other factors like interest rates, inflation, and market expectations when analyzing exchange rates. Therefore, a critical examination of the PPP theory reveals the need for a more comprehensive approach to understanding exchange rate dynamics.

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