What is purchasing power parity (PPP) and when does it hold?

• A. PPP states identical goods cost the same in different countries when priced in a common currency; holds in the long run under arbitrage.
• B. PPP requires identical currencies.
• C. PPP holds always in all situations.
• D. PPP is about government debt levels.

Answer: (A)

Purchasing power parity is the idea that when prices are converted to a common currency, identical goods should cost the same across countries. This follows from the law of one price: if a tradable good sells for different prices in two countries, arbitrage would buy where it’s cheaper and sell where it’s dearer, pushing prices and exchange rates toward equality. In practice, PPP tends to hold in the long run because arbitrage and market adjustments have time to work, but in the short run deviations can persist due to transport costs, trade barriers, differences in non-tradable goods like housing and services, product quality differences, and sticky prices or expectations. It’s not about government debt levels, and it doesn’t require identical currencies.