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PURCHASING POWER PARITY THEORY

Of the many influences on exchange rates

mentioned in Chapter 6, one factor is considered to

be particularly important for explaining currency

movements over the long run. That factor is inflation.

In this chapter we examine the theory and

the evidence for a long-run connection between

inflation and exchange rates. This connection

has become known as the purchasing-powerparity

(PPP) principle. An entire chapter is

devoted to the exploration of this principle because

it plays an important role in foreign exchange risk

and exposure, and many other topics covered in the

remainder of this book.

The PPP principle, which was popularized by

Gustav Cassell in the 1920s, is most easily

explained if we begin by considering the connection

between exchange rates and the local-currency

price of an individual commodity in different

countries.1 This connection between exchange

rates and commodity prices is known as the law of

one price.

THE LAW OF ONE PRICE

Virtually every opportunity for profit will catch the

attention of an attentive individual somewhere in

the world. One type of opportunity that will rarely

be missed is the chance to buy an item in one place

and sell it in another for a profit. For example, if gold

or copper was priced at a particular US dollar price

in London and the dollar price was simultaneously

higher in New York, people would buy the metal in

London and ship it to New York for sale. Of course,

it takes time to ship physical commodities, and so at

any precise moment, dollar prices might differ a

little between markets. Transportation costs are also

involved in attempts to profit fromprice differences.

However, if there is enough of a price difference

between locations, people will take advantage of it

by buying commodities in the cheaper market and

then sell them in the more expensive market.2

People who buy in one market and sell in another

are commodity arbitragers. Through their...