IB200_Wk7_Foreign_Exchange_II

IB200_Wk7_Foreign_Exchange_II - $1.50/£ If the actual spot...

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IB 200 Discussion Section Week 7 20th/21th Oct 2011
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Agenda How are exchange rates determined? Law of One Price Purchasing Power Parity The Big Mac Index
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The Law of One Price (LOP) In an efficient market, all identical goods must have only one price . The value of identical products should be the same, when denominated in the same currency Example: 1 USD = 30,990.5 RUR If a sandwich costs $ 6 in U.S,
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Purchasing Power Parity (PPP) If LOP holds for each good, it should also hold for a consumption bundle. If a consumption basket costs $1,500 in the U.S. and £1,000 in the UK the PPP exchange rate would be
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Unformatted text preview: $1.50/£. If the actual spot rate was $1.80/£ this would indicate that the pound is overvalued (or the dollar is undervalued) Empirical Support for LOP? Reasons for deviation from the LOP • Transportation/distribution costs • Trade barriers • Fluctuation of exchange rates • Tradability of goods • Labor, land are non-tradable/not mobile • Price-setting by monopolies • VW sells cheaper cars in the U.S. and Coke sells for a higher price in Japan Questions about the Worksheet, part I and part II? Other questions?...
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This note was uploaded on 12/11/2011 for the course INTBUS 200 taught by Professor Tuli during the Fall '11 term at University of Wisconsin.

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IB200_Wk7_Foreign_Exchange_II - $1.50/£ If the actual spot...

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