Chapter 14

# Chapter 14 - Chapter 14 Prices and Exchange Rates...

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Chapter 14: Prices and Exchange Rates: Purchasing Power Parity Arbitrage usually roughly equates prices of similar goods worldwide when prices are expressed in a common currency. In case of foreign exchange markets, people buy the currency in the market where it is low and sell it in the market where it is high. Prices and exchange rates will adjust in both markets and this eventually leads to a one world price in one currency. It thus brings a link between prices and exchange rates. If prices of goods in different markets change, then exchange rates should change to keep the prices when measured in a common currency equal across countries. Suppose the price of a shirt in New York is \$20 and in London £10. Then if E \$/£ is the spot rate then Price of shirt in NY (\$) = E \$/£ * Price of shirt in London (in £) \$ 20 = \$2 * (£10) That is, E \$/£ should be \$2.00/£ if arbitrage works. The exchange rate will be called the PPP- exchange rate as will be seen below. If one of the prices of goods doesn’t adjust, then the exchange rate should adjust. If, for example, the price of the shirt in London increased to £11 /shirt while the price in New York did not change, then \$ 20 = \$1.8181 *(£11) That is, the exchange rate E \$/£ must also change from \$2.00 to \$1.8181. That is, the dollar should appreciate against the pound. Absolute Purchasing Power Parity (PPP) First view: The PPP exchange rate is given by the ratio of price levels (two PPIs or CPIs) in two different currencies between two countries. This is the PPP exchange rate , which can be different from the actual or realized rate. Let E

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## This note was uploaded on 04/03/2012 for the course ECON 300 taught by Professor Gang during the Fall '06 term at Rutgers.

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Chapter 14 - Chapter 14 Prices and Exchange Rates...

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