Such misalignments are seen as being caused by brief falsifications, either to the price of the good or the exchange rate, which should rapidly be eliminated by a coherent, profit-seeking forex market.
However, the truth is that such “misalignments” can go on and on for months if not even years. In other words, traders, investors or corporations who base short-term forex trading choices on the PPP model of exchange rate value do so at their own risk.
Pretty Poor Predictor
The track record of the PPP model over the short term leaves a lot to be desired, to the extent
it is known in the market as the “Pretty Poor Predictor”.
How can such misalignments occur in a free market economy where the price alteration mechanism should be instant?
If there is free trade between nations, a price differential in a good (or basket of goods) should create an arbitrage chance—you buy the good in the cheaper country. Such buying should push
up the currency in the cheaper country relative to the more expensive one. Yet still, this is not necessarily what happens over the short term. Why?
No Free Trade
We do not have perfectly free trade. Such a idea would suggest zero import tariffs, zero export subsidies and perfect competition across all business sectors.
Needless to say, this is not the case. Whatever progress we have made, we are not there yet. As a result, there remain significant trade-related price (and therefore exchange rate) distortions.
Alternation Mechanism Not Instant
During periods of market volatility, corporations may suspend setting prices and budget exchange rates until they have a better idea of where the suitable levels should be to hold competitiveness and margin.
Prices of Goods are Not the Most Significant Cause
A basic PPP theory is that the relative pricing of goods is the main driver of exchange rates. However, since the liberalization of capital markets, this may no longer be the case.
Goods may be Diverse in Different Countries
The reliability of the good should not be taken for granted as the same good may vary between
countries in terms of worth, price and speed to market.