Spot Rate Theory Questions

Question 1

Discuss the law of one price and it’s relation to the theory of Purchasing Power Parity

Answer 1

• law of one price is a representation of absolute PPP and does not hold in many instances in market application
• it states that the price of something regardless of location will be the same once exchange rates have been accounted for
• also known as absolute purchasing power parity and is a very strict assumption
• LOP doesn’t hold as requires no taxes, no transport costs, no storage costs, and no barriers to entry. Which is unrealistic
• the theory of PPP states that the exchange rate between two counties equals the ratio of the countries price levels
• PPP predicts that an increase in the currencies domestic purchasing power will be associated with a proportional currency appreciation

Question 2

Discuss what is meant by a managed exchange rate regime

Highlight how certain nations are able to maintain a fixed exchange rate

Answer 2

• within a fixed exchange rate regime central banks actively manage the value of an exchange rate by managing the amount of demand and supply for said currency
• a managed exchange rate is where a central monetary authority entirely controls the value of a nations foreign exchange
• Saudi Arabia and Argentina 1992
• indicates how this management takes place with the monetary authority buying and selling foreign exchange