The law of one price It implies that the dollar price of good i is the same wherever it is sold US=(Ese)X(pr where us Is the dollar price of good i when sold in the u.s E is the corresponding euro price in Europe s/e is the dollar/euro exchange rate Copyright C 2003 Pearson Education, Inc Slide 15-6
Copyright © 2003 Pearson Education, Inc. Slide 15-6 – It implies that the dollar price of good i is the same wherever it is sold: P i US = (E$/€) x (P i E ) where: P i US is the dollar price of good i when sold in the U.S. P i E is the corresponding euro price in Europe E$/€ is the dollar/euro exchange rate The Law of One Price
Purchasing Power Parity Theory of Purchasing Power Parity(PPP The exchange rate between two counties currencies equals the ratio of the counties' price levels It compares average prices across countries It predicts a dollar/euro exchange rate of E (15-1) where us Is the dollar price of a reference commodity basket sold in the United States Pe is the euro price of the same basket in Europe Copyright C 2003 Pearson Education, Inc Slide 15-7
Copyright © 2003 Pearson Education, Inc. Slide 15-7 Purchasing Power Parity ▪ Theory of Purchasing Power Parity (PPP) • The exchange rate between two counties’ currencies equals the ratio of the counties’ price levels. • It compares average prices across countries. • It predicts a dollar/euro exchange rate of: E$/€ = PUS/PE (15-1) where: PUS is the dollar price of a reference commodity basket sold in the United States PE is the euro price of the same basket in Europe
Purchasing Power Parity By rearranging Equation(15-1), one can obtain PUS =(ESeX (pe) S/e/X PPP asserts that all countries' price levels are equal when measured in terms of the same currency Copyright C 2003 Pearson Education, Inc Slide 15-8
Copyright © 2003 Pearson Education, Inc. Slide 15-8 Purchasing Power Parity ▪ By rearranging Equation (15-1), one can obtain: PUS = (E$/€) x (PE ) ▪ PPP asserts that all countries’ price levels are equal when measured in terms of the same currency
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 Proponents of the PPP theory argue that its validity does not require the law of one price to hold exactly Copyright C 2003 Pearson Education, Inc Slide 15-9
Copyright © 2003 Pearson Education, Inc. Slide 15-9 ▪ 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. • Proponents of the PPP theory argue that its validity does not require the law of one price to hold exactly. Purchasing Power Parity
Purchasing Power Parity Absolute ppp and relative ppp Absolute ppp It states that exchange rates equal relative price levels Relative ppp It states that the percentage change in the exchange rate between two currencies over any period equals the difference between the percentage changes in national price levels Relative ppp between the United States and Europe would be (EseEt-Es/et-l/Ese-1=TUSt-TE.t(15-2) where 兀,= inflation rate Copyright C 2003 Pearson Education, Inc Slide 15-10
Copyright © 2003 Pearson Education, Inc. Slide 15-10 ▪ Absolute PPP and Relative PPP • Absolute PPP – It states that exchange rates equal relative price levels. • Relative PPP – It states that the percentage change in the exchange rate between two currencies over any period equals the difference between the percentage changes in national price levels. – Relative PPP between the United States and Europe would be: (E$/€,t - E$/€, t –1 )/E$/€, t –1 = US, t - E, t (15-2) where: t = inflation rate Purchasing Power Parity