Exchange rates and price levels The law of one price The relationship between price levels and exchange rate movements is largely explained by the theory of purchasing power parity, based on the economic proposition of the law of one price According to the law of one price, identical products sold in different countries must sell at the same price when the items' prices are expressed in the same currency,, .assuming the existence of competitive markets free from tariff and non tariff barriers and trade and transportation costs Purchasing parity The accepted economic theory of purchasing power parity (PPP) states that the exchange rate between any two currencies adjusts to reflect differences in price levels in the two countries The theory states that the price of a basket of goods should be the same in each country and predicts that the exchange rate will change if relative prices change. Differences national inflation rates are a main cause of changes in the relative prices of goods and services in a country. These price changes, in turn, are the major changes or adjustments in exchange rates where a country's inflation rate is believed to be a function of the growth supply A distinction is made between absolute purchasing power parity and relative purchasing power parity Absolute PPP means that a commodity service costs the same, regardless where it is sold or what currency it is sold Relative PPP does not serve as an indicator of absolute level of exchange rates, but rather of the change in exchange rates over time According to relative PPI*, a change in the bilateral exchange rate is determined by the differences in the inflation rates between the two countries, and the bilateral spot rate See TB for calculation Relative PPP tells us that the exchange rate between South Africa and some foreign country will change if the South African inflation rate is higher or lower than that of the foreign country. See TB
Exchange rates and price levels The law of one price The relationship between price levels and exchange rate movements is largely explained by the theory of purchasing power parity, based on the economic proposition of the law of one price According to the law of one price, identical products sold in different countries must sell at the same price when the items' prices are expressed in the same currency,, .assuming the existence of competitive markets free from tariff and non tariff barriers and trade and transportation costs Purchasing parity The accepted economic theory of purchasing power parity (PPP) states that the exchange rate between any two currencies adjusts to reflect differences in price levels in the two countries The theory states that the price of a basket of goods should be the same in each country and predicts that the exchange rate will change if relative prices change. Differences national inflation rates are a main cause of changes in the relative prices of goods and services in a country. These price changes, in turn, are the major changes or adjustments in exchange rates where a country's inflation rate is believed to be a function of the growth supply A distinction is made between absolute purchasing power parity and relative purchasing power parity Absolute PPP means that a commodity service costs the same, regardless where it is sold or what currency it is sold Relative PPP does not serve as an indicator of absolute level of exchange rates, but rather of the change in exchange rates over time According to relative PPI*, a change in the bilateral exchange rate is determined by the differences in the inflation rates between the two countries, and the bilateral spot rate See TB for calculation Relative PPP tells us that the exchange rate between South Africa and some foreign country will change if the South African inflation rate is higher or lower than that of the foreign country. See TB
MNI3701-Chap-6.docx