M06_MOFF9242_03_IM_C06 - Chapter 6 International Parity Conditions Questions 1 Purchasing Power Parity Define the following terms a The law of one price

# M06_MOFF9242_03_IM_C06 - Chapter 6 International Parity...

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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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