Define Purchasing Power Purity (PPP) and the Law of One Price, and describe how

Question

Define Purchasing Power Purity (PPP) and the Law of One Price, and describe how the two concepts are related. Suppose that the price of one ounce of gold in the United States is $1,200, while the price of one ounce of gold in Germany is 1, 050. According to the law of one price, what should be the Euro/Dollar exchange rate? If the current exchange rate Euro/Dollar is 0.92/USD, what should happen to the dollar (appreciate or depreciate) if the law of one price holds? Briefly explain. Briefly explain the information given in Table 1 of the article. What does it mean that the PWT and Big Mac indexes for Brazil are 45 and 66 respectively in terms of the Brazilian Heal being undervalued or overvalued? What does it mean for Japan that its PWT and Big Mac indexes are 145 and 111, respectively? Suppose the inflation rate in the United States is 4% per year, while in Japan the inflation rate is 1.5% per year. According to Relative PPP, which currency should depreciate and by how much per year? List and briefly explain the three main reasons why the PPP theory fails to predict exactly the behavior of exchange rates among currencies.

Explanation / Answer

Ans 1 - Purchasing power parity is defined as a theory which states that currency exchange rates equilibrium is achieved when the purchasing power is same in any two countries.

Law of one pruice states that any good must be sold at the same price anywhere in the world.

Both are related in the sense that purchasing power parity in an indirect sense promotes law of one price. This means that due to exchange rates the purchasing power or the price of a commodity is either the same or close in any given two locations (countries).

Ans 2 - The exchange rate of Euro/Dollar should be 1050/1200 = 0.875/USD

If the law of one price holds then the exchange rate should be 0.875/1 which is lower than the current rate of 0.92/1 which means the dollar will lose its value and become more cheaper that is depreciate.

Ans 3 - Table required

Ans 4 - The US dollar should depreciate as it has a higher inflation rate. It will depreciate by (1.5 / 4) - 1 = -0.625%.

Ans 5 - The theory proposes a direct functional relation between the purchasing powers of the currencies of two countries and their exchange rate. However, in reality there is no such direct and precise link between the two. There are many factors apart from the purchasing power of currencies, such as tariff, speculation, capital flows, etc., which significantly affect the rate of exchange.

According to the theory, to calculate the new equilibrium rate one must know the base rate i.e., the old equilibrium rate. But it is difficult to ascertain the particular rate which actually prevailed between the currencies as the equilibrium rate.

Moreover, the calculated new rate would represent the equilibrium rate at purchasing power parity only if economic conditions have remained unchanged.

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