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1 Lesson 57 1 Purchasing Power Parity An increase in U.S. prices reduces the attractiveness of U.S. goods, causing value of dollar to fall An increase in foreign prices reduces attractiveness of foreign goods, causing value of foreign currency to fall (dollar to appreciate) In this lesson, we are more specific, quantifying the change Lesson 57 2 The law of one price (LOOP) In the absence of transactions costs and information barriers, identical products have to sell for the same price (when measured in a common currency) regardless of location Reason is arbitrage (buy low, sell high) Lesson 57 3 Suppose this were not true Suppose that bread in New York sold for \$5 per loaf, while bread in Detroit sold for \$2 per loaf Arbitrageurs would load up trucks in Detroit and ship the bread to New York, making a profit of \$3 per loaf Higher demand for Detroit bread drives up price in Detroit, greater supply in New York drives price down there

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2 Lesson 57 4 Now imagine the two cities are in different countries Loaf of bread in London is £2, in New York it is \$5 Do these prices satisfy LOOP? Need to convert prices to common currency Lesson 57 5 Define some notation Price of bread in New York (dollars) B P = * Price of bread in London (pounds) B P = exchange rate (dollars per pound) E = Lesson 57 6 Dollar cost of bread in London: * B E P × * B B PE P So then LOOP holds if
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