THE BASIC LOGIC OF Purchasing POWER PARITY

The theory of purchasing-power parity is based on a principle called the law of one price. This law asserts that a good must sell for the same price in all locations. Otherwise, there would be opportunities for profit left unexploited. For example, suppose that coffee beans sold for less in Seattle than in Boston. A pennon could buy coffee in Seattle for, say, $4 a pound and then sell it in Boston for $5 a pound, making a profit of $1 per pound from the difference in price. The process of taking advantage of differences in prices for the same item in different markets is called arbitrage. In our example, as people took advantage of this arbitrage opportunity, they would increase the demand for coffee in Seattle and increase the supply in Boston.

Now consider how the law of one price applies to the international marketplace. If a dollar (or any other currency) could buy more coffee in the United States than-in Japan, international traders could profit by buying coffee in the United States and selling it in Japan. This export of coffee from the United States to Japan would drive up the U.S. price of coffee and drive down the Japanese price. Conversely, if a dollar could buy more coffee in Japan than in the United States, traders could buy coffee in Japan and sell it in the United States. This import of coffee into the United States from Japan would drive down the U.S. price of coffee and drive up the Japanese price. In the end, the law of one price tells us that a dollar must buy the same amount of coffee in all countries.

This logic leads us to the theory of purchasing-power parity. According to this theory, a currency must have the same purchasing power in all countries. That is, a U.S. dollar must buy the same quantity of goods in the United States and Japan, and a Japanese yen must buy the same quantity orgasm Tap  and the United States. Indeed, the name of this theory describes it well. Parity means equality, and purchasing power refers to the value of money in terms of the quantity of goods it can buy. Purchasing power parity states that a unit of a currency must have the same real value in every country.