# ECO230Y1 Lecture Notes - Lecture 19: Money Supply, Nominal Interest Rate, Interest Rate

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Published on 30 Apr 2016
School
UTSG
Department
Economics
Course
ECO230Y1
PRICE LEVEL AND EXCHANGE RATE IN LONG RUN
Chapter 16
The Law of One Price:
The Law of One Price: One good should have the same price everywhere as long as
you express the price in the same currency/ Identical products must sell at the same
price in different countries when prices are prices expressed terms of the same
currency, if:
1) Markets are competitive
2) No transportation cost
3) No official barriers to trade (tariffs, quotas…)
Consider a commodity like wheat:
UK: L1/bushel
 E = 2\$/L
Suppose E = 2\$/L.
UK L1.5/bushel
 Demand for wheat in Canada, so exported from Canada to UK
 Demand for wheat in Canada and supply in UK increase
 Price of wheat in Canada rises and it falls in UK
 Or, Canadian \$ may appreciate, as demand for it rises
The Purchasing Power Parity (PPP): Application of the law of one price to many
goods/ application of the law of one price across countries, for all goods and
services or a reference basket of goods and services
The law of one price shows the parity between each and every commodity in
two economies.
The purchasing power parity represents the parity between bundles of goods
and services
This means all countries have the same price levels, if prices expressed in
terms of the same currency.
IF the law of one price holds for each good, then the PPP relation holds, given that
bundles are similar in terms of goods and weights.
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PRICE LEVEL AND EXCHANGE RATE IN LONG RUN
Chapter 16
Suppose actual
exchange rate is:
Eactual = \$2/L
 the law of one
price holds for all
goods
Suppose actual
exchange rate is:
EActual = \$1.7/L
 The law of one
price does not
hold for the
goods.
Absolute PPP and Relative PPP
Absolute PPP: Expression of PPP in terms of levels of
exchange rate and price levels.
Relative PPP: Expression of PPP in terms of rates of change of exchange rate and
prices.
If absolute PPP
holds  Relative
PPP holds
If relative PPP
holds  Absolute
PPP may or may
not hold
This is because different countries use different bundles of goods to measure price
level, P.
Exchange Rate Determination; Monetary Approach (ALWAYS LONG RUN):
By Absolute PPP:
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## Document Summary

Demand for wheat in canada, so exported from canada to uk. Demand for wheat in canada and supply in uk increase. Price of wheat in canada rises and it falls in uk. Or, canadian \$ may appreciate, as demand for it rises. The purchasing power parity (ppp): application of the law of one price to many goods/ application of the law of one price across countries, for all goods and services or a reference basket of goods and services. The law of one price shows the parity between each and every commodity in two economies. The purchasing power parity represents the parity between bundles of goods and services. This means all countries have the same price levels, if prices expressed in terms of the same currency. If the law of one price holds for each good, then the ppp relation holds, given that bundles are similar in terms of goods and weights.