GDP Purchasing Power Parity (PPP) 2 — Questions and Answers
Question 1: If a standard basket of goods costs $100 in the United States and ¥1,200 in Japan, what is the PPP-implied exchange rate (dollars per yen)?
- ¥12 per dollar
- $0.083 per yen (Correct answer)
- $1.20 per yen
- $12 per yen
Correct answer: $0.083 per yen
The PPP exchange rate = US price / Japan price = $100 / ¥1,200 = $0.083 per yen, meaning one yen should be worth approximately $0.083 based on purchasing power.
Question 2: If the PPP-implied exchange rate is $1.25 per pound sterling but the market exchange rate is $1.50 per pound, the pound is considered to be:
- Undervalued relative to PPP
- Overvalued relative to PPP (Correct answer)
- At equilibrium with PPP
- Correctly valued but the PPP estimate is wrong
Correct answer: Overvalued relative to PPP
Since the pound trades at $1.50 in the market but PPP suggests it should only be worth $1.25, the pound is overvalued — it buys more dollars than its purchasing power justifies.
Question 3: Which of the following is a primary reason why absolute PPP does not hold precisely in practice?
- Countries deliberately manipulate price statistics
- Non-tradable goods and services can have vastly different prices across countries without triggering arbitrage (Correct answer)
- Central banks prevent all international currency transactions
- PPP calculations exclude services and only apply to manufactured goods
Correct answer: Non-tradable goods and services can have vastly different prices across countries without triggering arbitrage
Non-tradable items like haircuts, rent, and local utilities have prices that can diverge significantly across countries because they cannot be arbitraged internationally.
Question 4: The Balassa-Samuelson effect helps explain why richer countries tend to have higher overall price levels. Its core argument is that:
- Wealthy countries impose higher tariffs on imports, raising domestic prices
- Higher productivity in tradable sectors drives up wages economy-wide, making non-tradable services more expensive (Correct answer)
- Rich countries print more money, causing higher inflation across all sectors
- Large populations in rich countries create excess demand that raises prices
Correct answer: Higher productivity in tradable sectors drives up wages economy-wide, making non-tradable services more expensive
The Balassa-Samuelson effect shows that productivity gains in tradable goods raise wages throughout the economy, pushing up prices for non-tradable services and making rich countries more expensive overall.
Question 5: Relative PPP, as distinct from absolute PPP, predicts that:
- Identical goods will sell at the same absolute price in both countries
- Changes in exchange rates will reflect differences in inflation rates between countries over time (Correct answer)
- All countries will converge to the same income level
- Exchange rates are determined solely by trade flows
Correct answer: Changes in exchange rates will reflect differences in inflation rates between countries over time
Relative PPP focuses on changes: if Country A has higher inflation than Country B, Country A's currency should depreciate by approximately that inflation differential.
Question 6: If inflation in Country A is 6% and inflation in Country B is 2%, relative PPP predicts that Country A's currency will approximately:
- Appreciate by 4% against Country B's currency
- Depreciate by 4% against Country B's currency (Correct answer)
- Depreciate by 8% against Country B's currency
- Remain unchanged because both countries still have positive inflation
Correct answer: Depreciate by 4% against Country B's currency
Relative PPP predicts depreciation equal to the inflation differential (6% − 2% = 4%), as Country A's higher inflation erodes its currency's purchasing power.
Question 7: When comparing the economic size of China to the United States, using PPP-adjusted GDP rather than nominal GDP generally results in China's economy appearing:
- Smaller, because China's exchange rate is artificially suppressed
- Larger, because China's lower domestic price levels increase its PPP-adjusted output (Correct answer)
- Identical in size, because PPP eliminates all currency differences
- Smaller, because PPP penalizes countries with large populations
Correct answer: Larger, because China's lower domestic price levels increase its PPP-adjusted output
China's prices for many goods and services are lower than in the U.S., so PPP adjustment inflates China's GDP, often ranking it as the world's largest economy on a PPP basis.
GDP Purchasing Power Parity (PPP) 2
If a standard basket of goods costs $100 in the United States and ¥1,200 in Japan, what is the PPP-implied exchange rate (dollars per yen)?