The Basic Idea Underlying Purchasing Power Parity

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II. Purchasing Power Parity i. Intuition The basic idea underlying purchasing power parity is the law of one price. That is to say, once the prices of the same bundle of goods in different countries are measured using the same currency, they should be identical. As a consequence, no arbitrage in equilibrium will force the goods prices to be equalised internationally. Consider a situation where there are only 2 countries, say, China with the Chinese yuan as its currency unit and Japan with the Japanese yen as its currency unit. We can express the exchange rate as either the number of yuan per yen, or its reciprocal the number of yen per yuan. For instance, suppose that the exchange rate, defined as the number of yen it takes to buy one…show more content…
Thus, for this example, we can see that if PPP holds, there is equalisation in goods prices internationally. The key to the appealingness of PPP is that that if PPP is valid, then there is no goods arbitrage, which indicates that it is impossible that economic agents can gain riskless profit by exploiting price differences. Suppose the price of the good is 100 CNY in China and 2000 JPY in Japan, and the exchange rate is 0.01 CNY: 1 JPY. Then this good could be bought for 2000 JPY in Japan and imported into China (assuming no transportation costs) at selling at a price which when converted into yuan at the going exchange rate would be 20 yuan (=2000×0.01), some 80 yuan less than the domestic price. In this case, the existence of arbitrage opportunities will force the exchange rate to be adjusted in order to reflect the relative price of the good in the two countries. As a result, the exchange rate should adjust to 0.05 CNY: 1 JPY for the sake of ruling out arbitrage opportunities. It is assumed that there is no transportation costs in this example; however, even if transportation costs do exist, economic agents may still be able to gain riskless profit. If the cost of importation is 100 yen per unit, which is equal to 1 yuan at the current exchange rate, the imported good is still 79 yuan cheaper. ii. Complications of Testing PPP According to
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