360-14 - Chapter 14 Prices and Exchange Rates: Purchasing...

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Chapter 14 – Prices and Exchange Rates: Purchasing Power Parity (PPP) We start with the Law of One Price (LOP) : P D = E P F , where P D is the domestic price in $; P F is the foreign price, e.g., in £; and E is the $/£ ex-rate. LOP says that a tradable commodity like silver or gold should trade for the same price in U.S. and U.K., once compared in a common currency . Example: Silver sells for $4.50/oz in U.S., £2.50 in U.K. and E = $1.80/£, therefore: $4.50 = $1.80/£ x £2.50 and LOP holds. Silver sells for $4.50/oz in U.S. and $4.50/oz in U.K. ($1.80/£ x £2.50 = $4.50). Or we can say that silver sells for £2.50/oz. in U.K. and £2.50/oz. in the U.S. ($4.50 / $1.80/£ = £2.50). What if LOP didn’t hold? Suppose ex-rate was $1.78/£? Price in U.K. is £2.50 x $1.78/£ = $4.45/oz., and silver is still $4.50/oz in U.S. What would happen immediately? _________________________________________________. What would happen to silver prices in U.S. _________ and U.K._____________? What would happen to $ ________ and £ ____________? What would happen to $/£ ex-rate __________? Eventually, the LOP would be restored, through adjustments in silver prices, currency values and ex-rate. This tendency for similar goods to sell for similar prices (Price Equalization Principle) provides a link between prices and ex-rates, and leads to Purchasing Power Parity (PPP), which is the LOP extended to the entire price level. Absolute Purchasing Power Parity (PPP) : P D = E P F Where P D is the entire domestic (U.S.) price level measured by CPI or GDP Deflator, and P F is the entire foreign (U.K.) price level , measured by CPI or GDP Deflator. E = P D P F What if the U.S. price level (P D ) goes up and U.K. price level (P F ) stays the same. What happens to e? ___ Did the £ get stronger or weaker? _____ What about the $? ______ What if the U.K. price level goes up and U.S. price level stays the same. What happens to E? Did the £ get stronger or weaker? ___________ What about the $? ___________ Therefore, ex-rates change over time partly because as prices change internationally, ex-rates will change to keep prices measured in a common currency equal across countries. For 1/23/2012 1
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example, if everything in U.K. (U.S.) is cheaper than U.S. (U.K.), buying pressure in U.K. (U.S.) will appreciate the BP (USD). See Item 14.1, p. 359, on the U.S. Consumer Price Index. Issue: Are CPIs comparable? Why might LOP and PPP not hold? 1. 2. 3. 4. Changes in relative prices (the price of one good relative to another) are another reason why PPP might not hold. Prices reflect relative scarcity , which can change independently from changes in the price level. Example : Beef increases in price by 15% at the same time that chicken prices fall by 15%, leaving the CPI unchanged. Orange prices rise by 20% while apple prices fall by 20%, brick prices fall while wood prices rise, etc. Changes in relative prices could cause changes in the ex-rate even though price levels are constant, indicating a deviation
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This note was uploaded on 01/23/2012 for the course ECON 360 taught by Professor Staff during the Spring '11 term at University of Michigan.

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360-14 - Chapter 14 Prices and Exchange Rates: Purchasing...

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