PPP?

Some of you may be wondering since my last post, "Aren't things cheaper in pounds compared to dollars?" If so, you are a budding economist! [allow me to be a dork for a few minutes, you may actually find it interesting]

The Law of One Price suggests that identical goods and services can only have one price in an economy. Therefore, if I multiply the price of something in GBP by the spot exchange rate it should equal the price of the same good in the US priced in US dollars. Let's try an example: Say you would like to buy an iPod. If you were in the US you might head to Best Buy, there the 30 GB video iPod sells for $249.99. If you lived in the UK you might head to Curry's Digital where the same iPod sells for 189 GBP. Wait- if I multiply 189GBP * 1.95 $/GBP (the prevailing exchange rate) that equals $368.55!!

Ohhh, I left an important statement out of the law of one price. It should read "in an efficient market identical goods and services must have one price." I'll let you in on a secret, economics likes to assume lots of things. But when the assumptions don't hold the theories don't necessarily work. In this case an efficient market refers to a lack transportation and other significant transaction costs.

From the law of one price comes the theory of Purchasing Power Parity (PPP) that says exchange rates between currencies are in equilibrium when their purchasing power is equal in two countries. The theory is that market forces will drive out imbalances in the exchange rate. However, in addition to the fact that the market isn't really perfect as the theory assumes, there is a significant time element involved. In the short term exchange rates are driven by news (such as the weak economic forecast for the US last week). Thus people from the UK flock to the US for cheaper goods. But that's the beauty of it! This process will [over time] drive down the imbalance in the exchange rates so equilibrium is achieved.