International Parity Conditions.docx - INTERNATIONAL PARITY...

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INTERNATIONAL PARITY CONDITIONSInternational Parity Conditions in Equilibrium (Approximate Form)International Parity ConditionsoFundamental questions in international finance:What are the determinants of exchange rates?Are changes in exchange rates predictable?oThe economic theories which link exchange rates, price levels, and interest ratestogether are calledinternational parity conditionsoThese theories may not always work out to be ‘true’ in the real worldPrices and Exchange RatesoThelaw of one pricestates that all else being equal (no transaction costs orrestrictions) a product’s price should be the same in all marketsoWhen prices are in different currenciesP$x S = P¥oConversely, if the prices were stated in local currencies, and markets wereefficient, the spot exchange rate could be deduced from the relative localproduct pricesPurchasing Power Parity
oPurchasing Power Parity and The Law of One PriceIf the law of one price were true for all goods, thepurchasing powerparity (PPP)exchange rate could be found form any set of pricesThrough price comparison, prices of individual products can bedetermined through the PPP exchange rateAbsolute PPP states that the spot exchange rate is determined by therelative prices of similar baskets of goodsThis is the absolute theory ofpurchasing power parityThe “big mac index” bythe economistis a prime example of this law ofone price:Assuming that the Big Mac is identical in all countriesIt serves as a comparison point as to whether or not currenciesare trading at market pricesBig mac costs Yuan 16 in China and $4.56 in the USActual exchange rate Yuan 6.1341/SWhat is the price of a big mac in china in US dollar terms?

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Term
Fall
Professor
ElenaOburkhova
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