Financial Markets and Institutions (2-downloads)

theory of purchasing power parity (PPP). It states that exchange rates

between any two currencies will adjust to reflect changes in the price levels of

the two countries. The theory of PPP is simply an application of the law of one price

to national price levels.

As Example 1 illustrates, if the law of one price holds, a 10% rise in the yen price

of Japanese steel results in a 10% appreciation of the dollar. Applying the law of one

price to the price levels in the two countries produces the theory of purchasing power

parity, which maintains that if the Japanese price level rises 10% relative to the U.S.

price level, the dollar will appreciate by 10%. As our U.S./Japanese example illustrates,