This Week We Are Going To Explore The Concepts Of The Law

Q1this Week We Are Going To Explore The Concepts Of The Law Of One

This week, we are going to explore the concepts of the law of one price and the theory of purchasing power parity. In brief, these tell us that in the absence of trade barriers, the same product should cost the same in all countries (the law of one price). However, there are transaction costs and not all products can be traded internationally. These make the law of one price less useful in practice than it is in theory—at least for many products. The theory of purchasing power parity, on the other hand, does not have the limitations that the law of one price does.

Purchasing power parity tells us that the same product should take the same amount of purchasing power to buy, regardless of the country and currency involved. This approach is useful for international comparisons of numerous economic variables. This week, we are going to use it to look at currency exchange rates again. Think back to the currency you compared to the US dollar earlier in the course. Now we are going to ask the question: is that currency overvalued or undervalued?

That is actually a rather challenging question to answer. But The Economist has provided us with a rather interesting and quick way of reaching a surprisingly accurate answer to that question. The method is the Big Mac Index. Following are links to an informative video, a more recent article with Big Mac Index values, and an interactive currency comparison tool. The last two are from The Economist.

Currency Valuation with the Big Mac Index Read the 2014 Big Mac Index article: "The Big Mac Index." You will probably also want to use the interactive comparison tool: Global Exchange Rates, To Go Questions to address Is the currency of the country you studied previously overvalued or undervalued relative to the US Dollar? What does your finding suggest for the future behavior of your selected currency: Is it likely to appreciate or depreciate?

Paper For Above instruction

The Law of One Price (LOOP) and the theory of Purchasing Power Parity (PPP) are fundamental concepts in international economics that help explain how currency values and prices are related across countries. While they are interconnected and both aim to analyze price convergence, they differ in scope and applicability. This paper explores these theories, their limitations and strengths, and demonstrates their application using the Big Mac Index to assess currency valuation and predict future currency movements.

The Law of One Price posits that in an efficient market with no transportation costs, tariffs, or other trade barriers, identical goods should sell for the same price in different countries when prices are converted into a common currency. This assumption underpins many economic models but is often impractical due to real-world frictions such as shipping costs, tariffs, and differences in product quality. For example, variations in distribution channels or taxes can create price discrepancies, limiting the LOOP's predictive power in practice. Hence, the LOOP is more of a theoretical benchmark rather than a real-world phenomenon.

Conversely, the theory of Purchasing Power Parity extends the idea of price equality to the broader exchange rate level. PPP suggests that exchange rates should adjust over time to equalize the purchasing power of different currencies, reflecting changes in price levels. This theory is particularly useful for comparing living standards across countries and analyzing long-term currency trends. PPP can be expressed as the relative version, stating that the percentage change in exchange rates over time should equal the difference in inflation rates between two countries, which helps forecast currency appreciation or depreciation.

Despite their usefulness, both theories have limitations. The LOOP often fails in practice due to market imperfections, while PPP can be influenced by factors like capital flows, government interventions, and differing inflation expectations. Still, PPP provides a more flexible framework for analyzing long-term currency movements, especially when used in conjunction with empirical tools like the Big Mac Index—a simplified, yet insightful, measure of currency valuation.

The Big Mac Index, introduced by The Economist in 1986, serves as an accessible indicator of currency overvaluation or undervaluation. Its premise relies on the PPP theory: since a Big Mac is a standardized product globally, its price in different countries (converted into USD) should reflect the relative value of currencies. If a country's Big Mac costs significantly more than in the US, its currency may be overvalued; if less, undervalued. Using this index alongside other economic indicators helps analysts gauge whether a currency is fairly valued and predict potential future movements.

For example, considering the current data from The Economist's recent Big Mac Index, if a country’s Big Mac price in USD exceeds the actual exchange rate implied by PPP, it indicates overvaluation, suggesting the currency may depreciate to align with purchasing power levels. Conversely, if the local price in USD is below the PPP estimate, the currency might be undervalued and may appreciate. Such assessments, while simplified, can provide valuable insights into currency trends, especially for short-term investment and policy decisions.

Applying this to a previous comparison—say, the Euro versus the USD—you might find that the Euro appears overvalued according to the Big Mac Index. This could imply potential depreciation of the Euro in the future, aligning with market expectations driven by economic fundamentals and monetary policies. However, real-world currency movements are also affected by interest rates, political stability, and global economic developments, which should be considered alongside PPP-based analyses for comprehensive evaluations.

In conclusion, while the Law of One Price offers a theoretical ideal, practical limitations restrict its applicability. Purchasing Power Parity, complemented by tools like the Big Mac Index, provides a more feasible approach for assessing currency valuation and forecasting trends. Investors, policymakers, and economists benefit from these insights, although they must interpret them within the broader context of global economic forces.

References

• Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2018). International Economics (11th Edition). Pearson.
• Economist Intelligence Unit. (2023). The Big Mac Index 2023. The Economist. Retrieved from https://www.economist.com/big-mac-index
• Rogoff, K. (1996). The Purchasing Power Parity Puzzle. Journal of Economic Literature, 34(2), 647-668.
• Taylor, J. B. (2004). The Economics of Exchange Rates. Journal of Economic Perspectives, 18(3), 113-134.
• Frankel, J. A. (1986). International Price Levels and the Purchasing Power Parity Doctrine. The Economic Journal, 96(381), 1-20.
• Baqaee, D., & Farhi, E. (2018). Durable Goods and Temporary Income Shocks. The American Economic Review, 108(9), 2502-2544.
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