2007-6 PPP THEOREM

Purchasing Power Parity (PPP) is uesd to make predicition about the effects of inflation on exchange rates (e) . Accroding to the theory, differences in domestic inflation rates are a major cause of adjustments in the exchange rates.

(i)inflation rate in local higher than other countries --- local curriency depreciate
(ii) inflation rate in local lower than other countries --- local curriency appreciate

The PPP theory can also be known as "law of one price".

If the big Mac of HK is cheaper than the same big Mac in USA, then people in USA will practise arbitrage (buy low sell high) , buy low (in HK) and sell high in USA in order to make profit. During the process of arbitrage, the e of the country with cheaper price will rise and the e of the country with higher price will be fall.

***The equilibrium point will be that the price of the same good will be the same all around the world due to the adjustment of the e caused by price difference. (Thus there is "law of one price")

For example, if country A's inflation rate is 10% a year while inflation in the rest of the world is 12% a year , then the PPP theory predicts that country A will appreciate by 2% a year.

PPP may hold only when
(1)transaction cost =0
(2)homogenous good

2008-04-05 18:02:50 補充：
The law of one price state that, in terms of the same currency, a good that is freely traded around the world should command the same price in different countries.
The uniform price is a result of elimination of cross- country price differentials through arbitage.