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CHAPTER 4
PARITY CONDITIONS AND CURRENCY FORECASTING
ARBITRAGE AND THE LAW OF ONE PRICE
THE LAW OF ONE PRICE
A.Law states: Identical goods sell for the same price worldwide.
B.Theoretical basis :If the price after exchange-rate adjustment were not equal, arbitrage in the goods worldwide ensures eventually it will.
C.Five Parity Conditions Result From These Arbitrage Activities 1. Purchasing Power Parity (PPP) 2. The Fisher Effect (FE) 3. The International Fisher Effect(IFE) 4. Interest Rate Parity (IRP) 5. Unbiased Forward Rate (UFR)
D.Five Parity Conditions Linked by 1.The adjustment of various rates and prices to inflation 2.The notion that money should have no effect on real variables (since they have been adjusted for price changes).

PART II. **PURCHASING POWER PARITY
I.THE THEORY OF PURCHASING POWER PARITY: Purchasing Power parity was first stated in rigorous manner by the Swedish economist Gustav Cassel in 1918.He used the term in an article in the economic journal in1918 to explain that the exchange rate between two countries should be in the same ratio as the price level of those countries.states that spot exchange rates between currencies will change to the differential in inflation rates between countries.
II.ABSOLUTE VERSION OF PURCHASING POWER PARITY A.Price levels adjusted for exchange rates should be equal between countries. B.One unit of home currency should have the same purchasing power around the world.

Example; A Big Mac in Britain cost ₤1.90 on march 30, 1999 and US price of Big Mac $2.43. What was the PPP exchange rate of $ and ₤? The actual exchange rate of $/ ₤ was $1.61/ ₤. Determine the dollar value overvalued or undervalued?
Solution; PPP exchange rate=
Overvaluation of pound value;

III. RELATIVE VERSION PURCHASING POWER PARITY
A.states that the exchange rate of one

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