Purchasing Power Parity

Purchasing Power Parity - the same in America as abroad....

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Purchasing Power Parity The law of one price says that identical goods should cost the same in all countries. Profit opportunities ensure that the price of a good is the same all over the world. For example, suppose a yard of cloth costs $10 in the U.S. and the same yard of cloth produced by a French firm sells for 50 francs. The exchange rate between dollars and francs should be 50 francs = $10 or 5 francs = $1. If, at the going exchange rate, U.S. cloth is cheaper, the demand for dollars would go up, raising the value of the dollar. Purchasing power parity generalizes the law of one price to a group of goods. A basket of goods and services should cost the same in all countries after converting prices into the same currency. absolute PPP: r = P/P for relative PPP: % change in r = domestic inflation rate - foreign inflation rate Big Mac PPP The Big Mac is a collection of ingredients sold all over the world. Hence, it provides a good test of purchasing power parity. Big Mac PPP is the exchange rate that would leave burgers costing
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Unformatted text preview: the same in America as abroad. Let Big Mac PPP be equal to the foreign price in foreign currency divided by the American price in dollars. The foreign currency is overvalued if Big Mac PPP is greater than the actual exchange rate. Why does PPP fail? 1. transportation costs 2. barriers to trade 3. non-traded goods - price of a Big Mac reflects more than just the price of its ingredients 4. imperfect competition - able to engage in price discrimination 5. current account imbalances - trade in assets affects supply and demand for currencies Factors Affecting Exchange Rates foreigners demand dollars to • buy U.S. goods and services • buy U.S. assets Americans sell dollars to • buy foreign goods and services • buy foreign assets 1. changes in real GDP 2. expected future inflation 3. interest rates 4. shifts in demand 5. change in U.S. money supply 6. change in foreign money supply 7. expected future spot exchange rate...
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This note was uploaded on 11/22/2011 for the course FIN FIN1100 taught by Professor Bradrifkin during the Fall '09 term at Broward College.

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