chapter  8
34 Pages

The power of arbitrage—purchasing power and interest rate parities

ByJoseph P. Daniels, David D. VanHoose

The idea of purchasing power parity (PPP) presumes the absence of factors such as costs of transportation, cross-country tax differentials, and trade restrictions. A proposition that the price of a good or service in one nation should be the same as the exchange-rate-adjusted price of the same good or service in another nation. Absolute PPP is a theory of exchange rates: If absolute PPP holds, then the bilateral spot exchange rate should equal the ratio of the price levels of the two nations. Hence, the demand and supply schedules in foreign exchange markets should move to positions yielding this bilateral exchange rate. By the mid-1980s, the purchasing power parity doctrine was in such doubt that The Economist magazine developed an initially satirical measure of PPP called the Big Mac Index. The problem with absolute purchasing power parity is that people in different countries often consume distinctive baskets of goods and services.