Question

Explain the Law of One Price. Give an example.

What is the Fisher Effect? Provide an example.

Answer 1

The law of one price is the economic theory that the price of a given security, commodity or asset has the same price when exchange rates are taken into consideration. The law of one price is another way of stating the concept of purchasing power parity. The law of one price exists due to arbitrage opportunities.

In other words,identical goods should sell for the same price in two separate markets. This assumes no transportation costs and no differential taxes applied in the two markets.

For example,

If a particular security is available for $10 in Market A but is selling for the equivalent of $20 in Market B, investors could purchase the security on Market A and immediately sell it for $20 on Market B, netting a profit without any true risk or shifting of the markets.

As securities from Market A are sold on Market B, prices on both markets shift in accordance with the changes in supply and demand. Over time, this would lead to a balancing of the two markets, returning the security to the state held by the law of one price.

The Fisher effect is an economic theory proposed by economist IrvingFisher that describes the relationship between inflation and both real and nominal interest rates. The Fisher effect states that the real interest rate equals to the nominal interest rate minus the expected inflation rate.

Fisher mathematically expressed this theory in the following way:

R Nominal = R Real + R Inflation

For example,

ifthe nominal interest rate on a savings account is 4% and the expected rate of inflation is 3%, then the money in the savings account is really growing at 1%. The smaller the real interest rate the longer it will take for savings deposits to grow substantially when observed from a purchasing power perspective.