Chapter 6
International Parity Conditions
Questions
1. Purchasing Power Parity.Define the following terms:
a.
The law of one price.
The law of one prices states that producers’ prices for goods or services
of identical quality should be the same in different markets; i.e., different countries (assuming
no restrictions on the sale and allowing for transportation costs). If a country has higher inflation
than other countries, its currency should devalue or depreciate so that the real price remains
the same as in all countries. Application of this law results in the theory of Purchasing Power
Parity (PPP).
b.
Absolute purchasing power parity.
If the law of one price were true for all goods and services,
the
purchasing power parity
exchange rate could be found from any individual set of prices. By
comparing the prices of identical products denominated in different currencies, one could determine
the “real” or PPP exchange rate which should exist if markets were efficient. This is the absolute
version of the theory of purchasing power parity. Absolute PPP states that the spot exchange rate
is determined by the relative prices of similar baskets of goods.
c.
Relative purchasing power parity.
If the assumptions of the absolute version of PPP theory
are relaxed a bit more, we observe what is termed
relative purchasing power parity
. This more
general idea is that PPP is not particularly helpful in determining what the spot rate is today,
but that the relative change in prices between two countries over a period of time determines the
change in the exchange rate over that period. More specifically,
if the spot exchange rate between
two countries starts in equilibrium, any change in the differential rate of inflation between them
tends to be offset over the long run by an equal but opposite change in the spot exchange rate.
2.
Nominal Effective Exchange Rate Index.
Explain how a nominal effective exchange rate index
is constructed.
An exchange rate index is an index that measures the value of a given country’s exchange rate against
all other exchange rates in order to determine if that currency is overvalued or undervalued. A
nominal
effective exchange rate index is based on a weighted average of actual exchange rates over a period
of time. It is unrelated to PPP and simply measures changes in the exchange rate (i.e., currency value)
relative to some arbitrary base period. It is used in calculating the real effective exchange rate index.
3.
Real Effective Exchange Rate Index.
What formula is used to convert a nominal effective exchange
rate index into a real effective exchange rate index?
A
real
effective exchange rate index adjusts the nominal effective exchange rate index to reflect
differences in inflation. The adjustment is achieved by multiplying the nominal index by the ratio
of domestic costs to foreign costs. The real index measures deviation from purchasing power parity,
and consequently pressures on a country’s current account and foreign exchange rate.

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