16-01-2014, 01:39 PM
Exchange Rate Determination
Exchange Rate.ppt (Size: 130 KB / Downloads: 13)
Introduction
The theory of purchasing power parity (PPP) explains movements in the exchange rate between two countries’ currencies by changes in the countries’ price levels.
The price levels ( & changes in price level) in different countries determine the exchange rates between various currencies reflecting the purchasing power.
The Law of One Price
Law of one price
Identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency.
Assumptions
Competitive markets, movement of goods
No transport costs
No official barriers to trade or tariffs
No Transaction Cost
Purchasing Power Parity
The Relationship Between PPP and the Law of One Price
The law of one price applies to individual commodities, while PPP applies to the general price level.
If the law of one price holds true for every commodity, PPP must hold automatically for the same reference baskets across countries if each commodity is traded.
Explaining the Problems with PPP
International Differences in Price Level Measurement
Government measures of the price level differ from country to country because people living in different counties spend their income in different ways.
PPP in the Short Run and in the Long Run
Departures from PPP may be even greater in the short- run than in the long run.
Example: An abrupt depreciation of the dollar against foreign currencies causes the price of farm equipment in the U.S. to differ from that of foreign’s until markets adjust to the exchange rate change.