Macroeconomics Homework Essay

1 - Macroeconomics Homework Essay introduction. Describe Purchasing-Power Parity. What purpose does it serve? What are some of the limitations of the PPP?

      Purchasing-Power Parity (PPP) is a theory which assumes that the exchange rates between different currencies of two countries are in balance if the purchasing powers of the two currencies are equal. It could be measured in terms of exchange rate between two countries by comparing the same with the price level of a given basket of goods and services from the two countries.   It is an economic theory just like the law of supply and demand where equilibrium of one price for two countries is attained despite differences of their currencies.  The theory however assumes the absence of transportation and other costs for the same basket of goods such as transportation (Antweiler, 2008).  PPP is classified by economists as either absolute or relative.  Absolute PPP uses prices of an identical goods or services in both countries and one country’s purchasing power is measured using said country’s currency in relation to other country’s currency.  Relative PPP, on the hand, refers to inflation rates as measured by the rates of changes in price levels, whereby the rate of appreciation of one country’s currency is equated to difference of inflation rates between its home country with that of other of foreign country.  This means that a 2% inflation rate in the first country and 1% inflation rate in the second country will result to depreciation of the first country’s currency by 1% to equalize the inflation rates of the two countries (Antweiler, 2008).

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     PPP aims to measure the relative prices in different countries and can be used to determine real values of goods and services and for making indices of price levels from said countries (Statistics Denmark, n.d.).

      Limitations include the requirement of a competitive market of the goods and services for both countries and the fact that one price for two countries does apply only to goods or services which could be traded. Another limitation is its non-application to immobile goods and services which are exclusively produced locally by only one of the countries to be not covered by the theory of PPP (Antweiler, 2008).

2. What is Trade Policy? Describe and give examples of a trade policy.

      Trade policy covers any policy involving exchange of goods and services between two countries. It covers therefore policies on exports and imports as well as the related tariffs and non tariff barriers (Deardorff, 2001; Merchant and Snell, n.d.).

      Examples of trade policy include that of the bilateral trade agreements entered into by the US with Mexico and Canada through the North American Free Trade Agreement (NAFTA) where the represented three countries have eliminated a number of barriers to economic integration and which resulted to better economic ties. The US has also entered negotiations with other nations from the Western Hemisphere under the Free Trade Areas of the Americas (FTAA) (United States Department of Agriculture, 2008)

3. What is Capital Flight? What causes it and what are the effects?

      Capital flight is characterized by widespread speculation that is evidence by massive movement of private funds across borders and the movement must be large enough to affect the country from which the said private funds are taken. It must be distinguished from normal movement of funds as result of investment and financing activities of companies as a result on international finance.  The most common cause forwarded by economists is when there is a forecasted devaluation of home currency. Investors do not want to have to caught holding on to their assets in a foreign country expressed in the latter’s currency if the loss could be more than what could be earned by these companies in the normal course of events. Thus companies of foreign investors would like to find a way to secure the value of their investments by possibly buying gold or other currency (McLeod, 2002).

       The effects would be disastrous to economies from which the funds are taken out. Capital flight is normally associated with the movement of capital from Third World countries since these countries badly need foreign currency investments to beef up their economies due partly to need to trade with wealthier countries.  Since foreign currency investments are need to keep the economy going, capital flight could be considered as “external bleeding” by the third world countries and this could cause further economic problems to its already suffering citizens (McLeod, 2002).


Antweiler (2008) Purchasing Power Parity., {www document} URL ,  Accessed July 26,2008

Deardorff (2001), Deardorff’ Glossary of International Economics,. {www document} URL, Accessed July 26,2008

McLeod (2002) Capital Flight, {www document} URL,, Accessed July 26,2008.

Merchant and Snell (n.d.)  Macroeconomic and International Policy Terms, {www document} URL,  Accessed July 26,2008

Statistics Denmark (n.d.),  Declarations of content: Purchasing Power Parities, {www document} URL,, Accessed July 26,2008

United States Department of Agriculture (2008) What is Agricultural Trade Policy? {www document} URL, Accessed July 26,2008


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