FREE online courses on Investment Decisions in Exchange Rates - Absolute Purchasing Power Parity - The Law of One Price

 

The exchange rate between any pair of currencies is roughly equal to the ratio of the domestic and foreign prices of any good that may be freely traded (traded goods) between the two countries with minor (per unit) shipping costs.  In other words, the price of a good in dollars should be equal the price of that good in British pounds after the price in British pounds has been converted to a dollar price using the prevailing exchange rate between the dollar and the British pound.  Formally,

 

                   P=     S$/£ P,

 

which implies that

 

                   S$/£     =       .

 

The arbitrage mechanism required for Purchasing Power Parity is to hold depends on

 

1. Low per unit cost of trading and shipping commodities from one country to another,
2. Absence of barriers to trade such as taxes and tariffs,
3. Standard definition of the goods in question.

 

The conditions which permit Purchasing Power Parity to hold give rise to the distinction between

 

1. Traded Goods  (e.g., crude oil, wheat, and soybean meal)
2. Non-Traded Goods  (e.g., haircuts)