Purchasing Power Parity and International Commodity Arbitrage

Purchasing Power Parity and International Commodity Arbitrage

Foreign Exchange

Foreign exchange refers to two different things. The first is currency claims expressed in the equivalent value in foreign money. The second is actual transactions involving the conversion of money of one country into that of another.

Foreign exchange is necessary because different countries have different monetary units. One country’s currency typically cannot be used in another country. The determination of the price at which the currency of one country will be or should be exchanged for that of another country is the basis of this and many other essays and studies.

Foreign exchange is a commodity, and its price fluctuates based on supply and demand, like any commodity. This is not the place for a complete discussion of supply and demand as relates to foreign exchange, but for our purposes, we will assume that supply of and demand for a country’s currency moves along with the supply of or demand for that country’s products or the products of its trading partners. For example, if one country buys many more goods from its neighbor than its neighbor buys from it, the balance of payments at the end of the year will cause its neighbor’s currency to be in great demand, thereby driving its price up.

What in fact sets the exchange ratio between two currencies? Obviously supply and demand, but what causes supply and demand to set exchange rates at appropriate levels? With this question we begin the next section.

What is Purchasing Power Parity?

Perhaps the single most well known concept in foreign exchange theory is that of Purchasing Power Parity (PPP). The basic idea of PPP is that currencies represent purchasing power over goods and services. Either the exchange rate or price levels adjust to keep purchasing power constant. For example, say a particular basket of goods sells for $2000 in America and 1000 GBP in Great Britain. According to PPP, the exchange rate of dollars to pounds should be 2:1. If it were not 2:1; if, for example only 1.5 dollars was needed to purchase 1 pound, an arbitrageur would buy the basket of goods for 1000 pounds ($1500) and resell them in America for $2000. He would continue to do this until currency traders realized that they were being underpaid for their pounds and started to charge two dollars each for them, or Americans realized that they were paying too much for these goods and became willing to pay only $1500 for them, or some combination of the two.