Microsoft Word - Money, Banking, and Int Finance(scribd).docx

Money, Banking, and International Finance

after adjusting for transportation costs. If a price difference exists between two markets, then
arbitrage is possible. Traders would buy products from the low-price market and sell products to
the expensive market. Consequently, prices would converge to one price across all markets as
traders shifted supply from the low-price market to the high-price market. The high prices would
fall while the low prices would rise over time.
Price could differ between markets because the price difference reflects the transportation
costs of shipping the product from one market to another. Nevertheless, the Purchasing Power
Parity helps predict changes in exchange rates. For example, the petroleum price equals $90 per
barrel in the United States and 850 pesos per barrel in Mexico. Implied exchange rate equals one
U.S. dollar equals 9.4 4 4 Mexican pesos (or pesos 850 ÷ $90). If the actual exchange rate is $1 =
10 Mexican pesos, then the U.S. dollar is overvalued while the peso is undervalued. Actual
exchange rate means a $90 per barrel of petroleum costs $85 per barrel in Mexico.
Consequently, the traders could buy petroleum from Mexico, and they ship and sell petroleum to
United States. Over time, the petroleum price rises in Mexico because the traders reduced
petroleum supply while the petroleum price decreases in United States because the petroleum
supply increases. Eventually, arbitrage stops, when the prices converge between both countries.
Thus, Purchasing Power Parity estimates the equilibrium exchange rate.
Economists expand the Purchasing Power Parity to include many products in a society.
Then economists can compare a basket of goods of one country to another country. Consumer
Price Index (CPI) is a measure of a basket of goods in the United States. The CPI is an
aggregate measure of prices, and economists use it to measure inflation. The Absolute
Purchasing Power Parity states the foreign exchange rate between two currencies is the ratio of
the two countries’ general price levels. We define the notation as:

 Domestic price level for home country equals Pd.

 Foreign price level equals Pf.

 Spot exchange rate between countries equals S.

We define the absolute PPP exchange rate by Equation 3.

d

f

P

P

S= (3)

For example, the CPI for the United States equals $755.3 while the CPI for Switzerland is
1,241.2 francs. Thus, the absolute PPP predicts the exchange rate should be 1.64 francs per U.S.
dollar that we calculated in Equation 4.

$ 1

=1.64^ francs

$755.3

1,241.2 francs

=

P

P

S=

d

f (4)