Limitations of Purchasing Power Parity Model

Hard Currency Exchange Rates Exchange Rate Models

As a financial analyst for an international corporation, you are evaluating the impact of exchange rate models on currency valuation, specifically in the context of the euro and the U.S. dollar. Your firm has been using the purchasing power parity (PPP) theory as a framework for understanding exchange rate movements. However, recent market conditions have led to discussions about the validity of PPP in explaining currency fluctuations in the short term.

In order to provide your management with a comprehensive analysis, you review various exchange rate models: the monetary approach, the asset market approach, and the PPP model itself. Each model has distinct assumptions and implications about how exchange rates are determined.

Based on your review, which of the following statements most accurately describes the primary limitation of the purchasing power parity (PPP) model in predicting short-term exchange rates?

PPP relies on the assumption of perfect competition and the absence of transaction costs, which rarely reflects real-world market conditions.

PPP is based on historical price levels, making it less effective in environments where prices change frequently.

PPP assumes that exchange rates adjust instantaneously to changes in inflation rates, which is generally not observed in practice.

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