Law of One Price

? The law of one price simply says that the same good in different
competitive markets must sell for the same price, when
transportation costs and barriers between markets are not
important.

a 6hy? Suppose the price of pizza at one restaurant is $20,

while the price of the same pizza at a similar restaurant across
the street is $40.

a 6hat do you predict to happen?

a Many people would buy the $20 pizza, few would buy the $40.
? Ronsider a pizza restaurant in Seattle one across the border in
Vancouver.

? The law of one price says that the price of the same pizza
(using a common currency to measure the price) in the two
cities must be the same if barriers between competitive
markets and transportation costs are not important:

PpizzaUS = (EUS$/Ranada$) x (PpizzaRanada)

PpizzaUS = price of pizza in Seattle

PpizzaRanada = price of pizza in Vancouver

EUS$/Ranada$ = US dollar/Ranadian dollar exchange rate

 Purchasing Power Parity
? Purchasing power parity is the application of the law of one price
across countries for all goods and services, or for representative
groups (´basketsµ) of goods and services.

PUS = (EUS$/Ranada$) x (PRanada)

PUS = price level of goods and services in the US

PRanada = price level of goods and services in Ranada

EUS$/Ranada$ = US dollar/Ranadian dollar exchange rate

? Purchasing power parity implies that

EUS$/Ranada$ = PUS/PRanada

a The price levels adjust to determine the exchange rate.

a If the price level in the US is US$200 per basket, while the

price level in Ranada is R$400 per basket, PPP implies that the
US$/R$ exchange rate should be US$200/R$400 =US$ 1/R$ 2

a Purchasing power parity says that each country·s currency has

the same purchasing power: 2 Ranadian dollars buy the same

amount of goods and services as does 1 US dollar, since prices
in Ranada are twice as high.
? Purchasing power parity comes in 2 forms:

Absolute PPP: purchasing power parity that has already been

discussed. Exchange rates equal price levels across countries.

E$/½ = PUS/PEU

Relative PPP: changes in exchange rates equal changes in

prices (inflation) between two periods:

(E$/½,t - E$/½, t ²1)/E$/½, t ²1 = VUS, t - VEU, t

where Vt = inflation rate from period t-1 to t

Relative PPP (contd«)

Assume that

 two countries have zero inflation

 exchange rate between them is in equilibrium

6ith passage of time, both countries may experience inflation

For PPP to hold, the exchange rate should adjust to balance

the differential in the inflation rates of the two countries

In this condition, the difference between the purchasing prices

of two countries gets diminished.
 Two of the most commonly proposed
reasons that PPP does not consistently
occurs:
1. Other influential factors

Other than inflation differential, exchange rates are

affected by other factors:

r ‰ifferentials in interest rate and income levels

r Government control (e.g. trade barriers)

©. No substitute for traded goods

 As per PPP, as soon as the prices become relatively

higher in one country, the other will discontinue

importing and shift to domestic purchases. This

influences exchange rate.

 6hat if substitute goods are not available domestically??

 Limitations
? ‰ifficulty in choosing the base period (reflects an

equilibrium position)

For e.g.- the 1978 base period shows a relatively overvalued

dollar

while, 1984 base period shows a relatively undervalued dollar.

? Main reason for abolishing fixed exchange rates

 Limitations

? PPP is more closely approximated in the long-run

than in the short-run, when disturbances are purely

monetary in character.

? In the short-run, however, exchange rates have been found

to deviate sharply from those predicted by the PPP theory.