Financial economics Essay Example | Topics and Well Written Essays - 2500 words

Financial economics - Essay Example Theories that have brought about pop assume that at some circumstances, it would cost exactly the same number of for exampleUs dollars to buy euros and then to use the proceeds to purchase the same basket as it would cost to use those US dollars directly in buying the market basket of goods. For example, a cake that sells for C$1.50 in Australian city should cost US$1.00 in a U.S. city when the exchange rate between Canada and the U.S. is 1.50 USD/CDN. (Both cakes cost US$1.00.) Therefore, the fundamental for PPP is the "law of one price". Consequently, on elimation or assumptiontransportation and other transaction costs, competitive markets will have same price for identical good in two countries, on expressing the prices of involved countries into the same currency. The concept and principle of purchasing power parity enables and aids in estimation of what the exchange rate between both currencies should be in order for the exchange to be the same with the purchasing capability of the currencies of the two countries. Thus, when a countrys domestic price level is increasing as it is in the case when it is experiencing inflation that countrys exchange rate must depreciated so as to stabilize the PPP. PPP exchange rates is significant in that it helps to avoid inaccurate and erroneous international comparisons that arise due to use of market exchange rates. A good example is when two countries output similar physical amounts of goods in two separate years. Due to adverse fluctuation in market exchange rates when the GDP of one country (measured in its own currency is converted to the other countrys currency using market exchange rates) one country can be deemed to have higher real GDP than the other country in one year but relatively lower in the other; both of these comparisons wouldmiss-reflect the reality of their relative levels of