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Principles of Economics- Mankiw (5th) 649

Principles of Economics- Mankiw (5th) 649 - CHAPTER 29...

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CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 671 long-run theory of exchange rates is based, as well as the theory’s implications and limitations. THE BASIC LOGIC OF PURCHASING-POWER PARITY The theory of purchasing-power parity is based on a principle called the law of one price. This law asserts that a good must sell for the same price in all locations. Oth- erwise, there would be opportunities for profit left unexploited. For example, sup- pose that coffee beans sold for less in Seattle than in Boston. A person could buy coffee in Seattle for, say, $4 a pound and then sell it in Boston for $5 a pound, mak- ing a profit of $1 per pound from the difference in price. The process of taking ad- vantage of differences in prices in different markets is called arbitrage. In our example, as people took advantage of this arbitrage opportunity, they would in- crease the demand for coffee in Seattle and increase the supply in Boston. The price of coffee would rise in Seattle (in response to greater demand) and fall in Boston
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