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Purchasing Power Parity - Papers

Purchasing Power Parity


and International Commodity Arbitrage
Foreign exchange refers to two different things. The first is currency claims expressed in the equivalent value in foreign money. The second is actual transactions involving the conversion of money of one country into that of another.
Foreign exchange is necessary because different countries have different monetary units. One country’s currency typically cannot be used in another country. The determination of the price at which the currency of one country will be or should be exchanged for that of another country is the basis of this and many other essays and studies.
Foreign exchange is a commodity, and its price fluctuates based on supply ...

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neighbor’s currency to be in great demand, thereby driving its price up.
What in fact sets the exchange ratio between two currencies? Obviously supply and demand, but what causes supply and demand to set exchange rates at appropriate levels? With this question we begin the next section.

What is Purchasing Power Parity?

Perhaps the single most well known concept in foreign exchange theory is that of Purchasing Power Parity (PPP). The basic idea of PPP is that currencies represent purchasing power over goods and services. Either the exchange rate or price levels adjust to keep purchasing power constant. For example, say a particular basket of goods sells for $2000 in America and 1000 GBP in Great Britain. According to PPP, the exchange rate of dollars to pounds should be 2:1. If it were not 2:1; if, for example only 1.5 dollars was needed to purchase 1 pound, an arbitrageur would buy the basket of goods for 1000 pounds ($1500) and resell them in America for ...

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Obviously, in a situation involving substantial transaction costs relative to the cost of the commodity in question, LOP will be empirically meaningless. Second, for this formulation to hold true, there must no barriers to trade. This would include prohibitions, tariffs, taxes, and quotas. Lastly, and perhaps most obviously, is that we must be comparing homogeneous goods.

The absolute version of PPP hypothesizes a similar relationship, with the exception that it uses price levels instead of specific commodity prices. Mathematically, the absolute version of PPP can be expressed thus:
P(t) = S(t) x P*(t), where
P(t) = the domestic price level in domestic currency
P*(t) ...

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PAPER DETAILS
Added: 1/27/2004 05:42:30 PM
Category: Miscellaneous
Type: Premium Paper
Words: 1416
Pages: 6

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