PPP & LOP

Purchasing Power Parity and Law of One Price

Purchasing Power Parity and Law of One Price

Introduction

Purchasing power parity (PPP) is theory which states that the rate between two should be equivalent to the ratio of the prices of same goods in the country so that single unit of the currency of one country should have same purchasing power in the other country. PPP was introduced several centuries ago, but the term was coined during World War I in the international policy debate regarding the suitable exchange rates between the industrialized inflation stricken nations after the war. Some think that PPP is a myopic scheme while some hold the belief that some variant of PPP might be used in long term exchange rate deviation (Zussman, 2002, p. 1-43).

The mechanisms underlying PPP are commodity arbitrage and strong correspondence of the economies both domestic and foreign. International Arbitrage that involves no cost is instantaneous and comprises of full information results in Law of One Price (LOP) for each good that is traded.

The conditions for LOP to be true are

All goods produced in either of the economies are traded.

The weight assigning pattern of all prices is identical.

Existence of perfect international commodity arbitrage.

If some of the commodities are not traded then following conditions must be held true.

Perfect substitutability of non traded or traded goods.

Economies similar enough to satisfy the conditions of perfect competition, unitary homogenous production methods, and indistinguishable production functions in both countries and same tastes (Officer, 2005, p. 4-68).

Critical Evaluation and Evidence

In the assumed absence of transport costs and trade restrictions, perfect commodity arbitrage insures that each good is uniformly priced (in common currency units) throughout the world -the “law of one price” prevails'. In reality the law of one price is fragrantly and systematically violated by empirical data (Isard, 1977, p. 942-948)

In light of above statement the following data has be evaluated critically

Purchasing Power Parity

The rationale behind PPP is that the unit of one currency should be able to buy the same amount of goods and services as the equivalent amount does. The idea of PPP may hold true mainly because of the law of one price. Law of one price states that he price of goods should be same anywhere when expressed in common currency. The possible objection which holds to this theory is the presence of transactions costs all across the globe. The transaction cost includes taxes, tariffs, and transportation costs. There are two reasons why PPP holds. Absolute PPP means that the one unit of currency can purchase goods and services in other countries at the same price like the foreign currency when converted. Relative PPP states that the change in exchange rate offsets the inflation rates in other countries. If absolute PPP exists then relative PPP also exists but if relative PPP exists that doesn't means absolute also exists because of the transaction costs of the currency conversion (Taylor and Taylor, 2004, p. 135-158).

PPP holds in short in some cases as well ...