Reference no: EM13730043

Use the internet to research recent causes for fluctuations in purchasing power parity. Provide specific examples.

According to Eun & Resnick, (2012), purchasing power parity is when the law of one price is applied internationally to a standard commodity basket. The theory further states that the exchange rate between currencies of two countries should be equal to the ratio of the countries' price levels. Purchasing Power Parity theory is based on the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at that rate of exchange are equal. For example, PPP is based on the fact that goods should cost the same in Canada and the United States once the exchange rate is taken into account. A more specific example is suppose one USD is currently selling for ten Mexican Pesos (MXN) on the exchange rate market. In the United States, baseball hats sell for $40 while in Mexico, they sell for 150 Pesos. Since 1 USD is equal to 10 MXN, then the hat cost $40 USD if purchased in the U.S. but only $15 USD if purchased in Mexico. Obviously there is an advantage to purchasing hats in Mexico making it better for consumers to purchase the hats in Mexico. If consumers decide to take advantage of the exchange rate and make the purchase in Mexico, the Mexican Peso will become more valuable relative to the U.S. dollar. The demand for this good in the U.S. will also decrease forcing the price American retailers charge to go down. Further, the demand for baseball hats in Mexico will also increase forcing the price charged by Mexican retailers to go up. Given this example, PPP is based on various factors that offset the price of goods in addition to the exchange rates between currencies. Transportation costs, barriers to trades, and other transaction costs can be significant to the law of one price. Competitive markets for goods and services across countries is another factor to be considered.

Discuss the implications of the deviations from purchasing power parity for countries' competitive positions in the world market.

Exchange rates may satisfy PPP as competitive positions of countries' will remain unaffected subsequent to exchange rate changes. On the other hand, exchange rate changes does affect competitiveness between countries because if a country's currency appreciates or depreciates, that will weaken or strengthen the country's competitive position in the world market.