Question

Purchasing Power Parity

1. (1 Point) Define the Law of One Price (LOOP), the Absolute Pur- chasing Power Parity (Abs. PPP), and the Relative Purchasing Power Parity (Rel. PPP).

2. (4 Points) Prove mathematically that the LOOP implies the Abs. PPP and the Rel. PPP.

3. (5 Points) Discuss how the LOOP, Abs. PPP, and Rel. PPP can fail.

Answer 1

Ans 1

The Law of One Price (LOOP) states that the price of identical asset or commodity will have same price globally irrespective of location when other factors are considered.The Law of One Price takes into account the frictionless market ,where there are no transaction costs, transportation costs, or legal restrictions, the currency exchange rates are the same, and that there is no price manipulation by buyers or sellers. The law of one price exists because differences between asset prices in different locations would eventually be eliminated due to the arbitrage opportunity.It is the foundation of purchasing power parity.

The Absolute Purchasing Power Parity (Abs.PPP) theory states that the price levels will be the same across countries.This theory holds good with the commodities which are easily transportable between two countries but it is false for other goods and services which cannot easily be transported, because the transportation costs will distort the parity.

The Relative Purchasing Power Parity(Rel.PPP) is an economic theory that states that exchange rates and inflation rates (price levels) in two countries should equal out over time.