No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Fifteen: Issues in International Economics 376 of as simply another price. As entrepreneurs become aware of price differentials for goods in different countries, they purchase goods in the cheap country to sell in the dear (or expensive) country to make a profit. To purchase these goods, entrepreneurs must purchase foreign exchange (FX). The buying and selling of FX leads to a market exchange rate. In the long run, the exchange rate of any currency is primarily driven by trade requirements (goods and services that are imported and exported). In the short run, however, the exchange rate is primarily driven by financial flows between countries. The idea that entrepreneurs will arbitrage price differences between countries (and over the long run guide trade flows) leads to a theory of exchange rates called purchasing power parity (PPP). PPP compares differences in price levels between economies to provide a theoretical exchange rate. PPP is an overall economy measure of the law of one price , which suggests that in the absence of transactions costs, tradable goods should sell for the same price in different locations. A common way to consider PPP and the law of one price is called the Big Mac Index, which compares the prices of Big Macs at McDonalds across the world. If Big Macs are priced differently, entrepreneurs should expect to see exchange rates adjust in the future to minimize that difference. MERCANTILISM VS. FREE TRADE Part of the concern over trade is the fact that trade imbalances don’t seem to happen without government manipulation of trade for political benefit. For example, the Chinese government currently pegs their currency against the dollar. This has the effect that their currency may be undervalued and contributing to China’s continued trade surpluses. China is not alone, of course, in managing the value of its currency for political benefit. Sometimes countries want a strong currency, other times they want a weak currency. It depends on their political objective and which special interest the leadership is trying to support. The Japanese occasionally intervene in foreign currency markets to keep the value of the Yen where they want it (we’ll discuss how they do this later), and the U.S. does too . When other countries accuse the U.S. of engaging in a currency war with its monetary policy and taking steps to fight back, and we accuse PURCHASING POWER PARITY AND BIG MACS Purchasing power parity requires goods that are tradable (think cars, not haircuts) in both countries to sell at the same price (adjusted for transactions costs)—otherwise there would be an opportunity for an entrepreneur to profit from any price differential driving the price difference down to zero. A popular press application is to compare the price of a “Big Mac” in different countries. Purchasing power parity (PPP): an application of the law of one price, which suggests that in the absence of transaction costs, goods should trade at the same price everywhere. Purchasing power parity calculates an exchange rate which would allow consumers to purchase a similar basket of goods in either country. Law of one price: In the absence of transactions costs, tradable goods should sell for the same price in different locations. Foreign exchange: foreign currencies used by private market participants to purchase foreign goods. Foreign exchange also refers to the markets where currencies are exchanged.