ECON103 Chapter Notes - Chapter ECON103: Substitute Good
A First Theory of Exchange-Rate Determination: Purchasing-Power
Parity
• Purchasing-Power Parity: a theory of exchange rates whereby a unit of any
given currency should be able to buy the same quantity of goods in all countries
o The theory of purchasing-power parity is based on a principle called the law of one
price. This law asserts that a good must sell for the same price in all locations.
o Parity means equality, and purchasing power refers to the value of money in terms of
the quantity of goods it can buy. Purchasing-power parity states that a unit of a
currency must have the same real value in every country.
• Implications of Purchasing-Power Parity:
o If the purchasing power of the dollar is always the same at home and abroad, then
the real exchange rate—the relative price of domestic and foreign goods—cannot
change.
o According to the theory of purchasing-power parity, the nominal exchange rate
between the currencies of two countries must reflect the price levels in those
countries.
e = P*/P.
o When the central bank prints large quantities of money, that money loses value both
in terms of the goods and services it can buy and in terms of the amount of other
currencies it can buy.
• Limitations of Purchasing-Power Parity:
There are two reasons the theory of purchasing-power parity does not always hold in
practice. The first reason is that many goods are not easily traded. The second reason that
purchasing-power parity does not always hold is that even tradable goods are not always
perfect substitutes when they are produced in different countries. Thus, both because some
goods are not tradable and because some tradable goods are not perfect substitutes with
their foreign counterparts, purchasing-power parity is not a perfect theory of exchange-rate
determination.
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Document Summary
This law asserts that a good must sell for the same price in all locations: parity means equality, and purchasing power refers to the value of money in terms of the quantity of goods it can buy. Purchasing-power parity states that a unit of a currency must have the same real value in every country: implications of purchasing-power parity: There are two reasons the theory of purchasing-power parity does not always hold in practice. The first reason is that many goods are not easily traded. The second reason that purchasing-power parity does not always hold is that even tradable goods are not always perfect substitutes when they are produced in different countries.