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Purchasing Power Parity PPP is the exchange rate determination used to compare the average cost of goods and services between countries What this theory implies is that the actions of importers and exporters are motivated by cross country price differences influencing changes in the spot exchange rate In essences what we have is transactions on one countrys current account affects the value of the exchange rate on the foreign exchange market The foreign exchange market uses the US dollar exchange The interest rate parity assumes the action of the investors influences the change in the exchange rate To understand PPP I had to break the concept down to a few different components Since the PPP is based on the theory and variations of the law of one price loOP it is necessary to understand the loOP theory The loOP says that identical goods should sell for the same price in two separate markets when there are no transportation costs and no differential taxes applied in the two marketsSuranovic Steven 1997-1999 So if a video sells for 20 in the US and the same video sells for 150 Mexican pesos in Mexico or converted to US dollars the same video would cost 15 US dollars in Mexico Since the dollar of price for the price of the video did not match the dollar price in the US the law of One Price does not hold Suranovic Steven 1997-1999 What might happen if the US tourist travels over to Mexico and buys up the CDs and brings them back to the US and sells them for the US market price A profit would be made Mexico in turn would increase it sale of the CD because of the laws of supply and demand It may then increase its prices The law of supply in demand would probably cause the US to bring down its prices So now Mexico and the US have the same selling price of
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