Make your own free website on Tripod.com
MFC yr. 2 Corner (AL試後檢討)
 

有同學來信話今年份Macro同以往 0既format好唔同,仲有fill in the blank,攪到有D不知所措。而且條IS-LM勁難,又考埋D  One Price Law,聽都未聽過!所以好驚......

為免大家咁樣,我講 0下 乜 0野係  One Price Law先:
 

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 location. Otherwise, there would be arbitrage opportunity for profit. For example: suppose that coffee beans sold for less in U.S.A. than in China. A person could buy coffee in U.S.A. for, say, $4 a pound and sell it in China for $5 a pound, making a profit of $1 per pound from the difference in price.

This process of taking advantage of differences in prices in different markets is called arbitrage.

In our example, as people took advantage of this arbitrage opportunity, they would increase the demand for coffee in U.S.A. and increase the supply in China. The price of coffee would rise in the U.S.A. (in response to greater demand) and fall in China (in response to greater supply). This process would continue until, eventually, the prices were the same in the two markets.

Now consider how the law of one price applies to the international market place. If a $U.S. dollar could buy more coffee in the U.S.A. than in China, international traders could profit by buying coffee in the United States and selling it in China. This export of coffee from the U.S.A. to China would drive up the U.S.A. price of coffee and drive down the Chinese price. Conversely, if a dollar could buy more in China than in the United States, traders could buy coffee in China and sell it in the U.S.A. This import of coffee into the U.S.A. from China would drive down the U.S.A. price of coffee and drive up the Chinese price. In the end, the law of one price tells us that a dollar must buy the same amount of coffee in all countries.

This logic leads us to the theory of purchasing power parity. According to this theory, a currency must have the same purchasing power in all countries. That is , a $U.S. dollar must buy the same quantity of goods in the United States and China, and a Chinese RMB must buy the same quantity of goods in China and the United States.

Indeed, the name of this theory describes it well. Parity means equality, and purchasing power refers to the value of money. Purchasing -power parity states that a unit of all currencies must have the same real value in every country.

This theory tells us that the nominal exchange rate between the currencies of the two countries depends on the price levels in those countries. If a dollar buys the same quantity of goods in the United States (where the prices are measured in $U.S dollar) as in China (where prices are measured in RMB), then the number of RMB per $U.S. dollar must reflect the prices of goods in the United States and China.

For example, if a pound of coffee cost 50 RMB in China and $5 in the United States, then the nominal exchange rate most be 10 RMB per $U.S. dollar (50 RMB / $U.S. 5 = 10 RMB per U.S. dollar). Otherwise, the purchasing power of the dollar would not be the same in the two countries.

i.e. exchange rate between two currencies = PA / PB , where PA is the general price level of country A, and  PB  is the general price level of country B.

This theory is usually examined in a situation of inflation in one country, but not another, and asking the effect of inflation on the forex rate between these two countries.

For my MFC yr. 2 students, do you still remember my last test (eventually turned in to a take home exercise), there is a question asking about an inflation occuring in the U.S., what will be the effect of its forex rate against Germany? This is a traditional question about the theory of purchasing power theory, though I have not mentioned its name when I explained it on class at that time.
 
 
 
 

Back to the front page