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Finance & Accounting
Pages 8 (2008 words)
Purchasing power parity theory of exchange rate is based on the idea of equivalence in the purchasing power of countries, which leads to equilibrium in the exchange rate between the currencies of countries.
This simply indicates uniformity in the prices of fixed number of goods and services and exchange rate of two countries. The roots of this theory lie in the law of one price, which says that homogenous goods should have identical prices universally not including any carrying or shipping costs under the prevalence of perfect competition if the pertinent national prices are stated in a common currency. The law of one price has certain conditions, which must exist in order for this law to be applicable. Firstly, it is the presence of competitive market for goods and services in two countries (EconomyWatch, 2010). Secondly, presence of goods and services that two countries can trade between themselves and lastly, checking of transportation and other operational expenses, which are obstructions in trade. Taking example of McDonald’s Big Mac hamburger prices around the world, one can understand this concept. For this the one should take the prices of all the countries in common currency, therefore dollar would be the appropriate one as every currency’s appreciation or depreciation is measured in terms of dollar (Taylor and Taylor, 2004, pp.135-158). In January 2004, the price of hamburger in United States was $2.80 where as in China it was $1.23, least expensive of all countries, this shows that China’s currency was underrated by 56%. ...
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