Nigerian Power

Reg No: 005

The relevance of purchasing power parity in the restoration of equilibrium, following a change in relative prices between two countries.

The purchasing power parity is a theory that states that exchange rates between currencies are in equilibrium when the currency of each of the two countries can purchase identical goods in the countries. I.e. the exchange rate between two countries should be equal to the ratio of the two country's price level of a fixed basket of goods and services.

Using an illustration of Nigeria and America, (given that N1= $2) if America's domestic price level increases (i.e. America is experiencing inflation) and it exports goods to Nigeria, and say goods which used to be $2 are now $4, this will make America's goods less attractive to Nigeria because Nigeria will need more of its naira to purchase the same amount of goods it used to buy before .i.e. it will need $2 for the $4 good which before it would have paid $1. Therefore, Nigeria will demand less of American dollars and this will eventually bid down the value of the dollars to N1 = $4 so that both currencies will be at par.

Again lets imagine (given that N1= $2) that a good in Nigeria which is N2 is $3 in American whereas it should be $4 it means people will rather import the good from America than buy it in Nigeria. This will increase the demand for the dollar and eventually bid up the value of the dollar. This process continues until the goods have again the same price.

It should be noted that purchasing power parity describes the long run behavior of exchange rates and not short run. The economic forces behind PPP will eventually equalize the purchasing power of currencies but it can take many years.

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