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Date Submitted: 02/23/2014 06:41 AM
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...