- The principle of purchasing power parity (PPP) is the macroeconomic counterpart to the microeconomic law of one price (LOOP). To express PPP algebraically, we can compute the relative price of the two baskets of goods in each location:
- There is no arbitrage when the basket is the same price in both locations qUS/EUR = 1. PPP holds when price levels in two countries are equal when expressed in a common currency. This statement about equality of price levels is also called absolute PPP.
The Relationship Between PPP and the Law of One Price - The law of one price applies to individual commodities, while PPP applies to the general price level.
- If the law of one price holds true for every commodity, PPP must hold automatically for the same reference baskets across countries if each commodity is traded.
- The relative price of the baskets is one of the most important variables in international macroeconomics, and it has a special name: it is known as the real exchange rate.
- The U.S. real exchange rate qUS/EUR = E$/€ PEUR/PUS tells us how many U.S. baskets are needed to purchase one European basket; it is the price of the European basket in terms of the U.S. basket.
- The exchange rate for currencies is a nominal concept. The real exchange rate is a real concept; it says how many U.S. baskets can be exchanged for one European basket.
- Inflation occurs when the quantity of money in circulation rises faster than the stock of goods and services
- Money supply growth related to currency value
- Relative inflation rates and trends can predict relative exchange rate movements
- When changes in relative prices in two countries change their currencies’ exchange rate, then the currency of the country with the highest inflation should decline in value
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