Global Financing and Exchange Rate Mechanisms Essay

Global Financing and Exchange Rate Mechanisms - show ExampleThe Purchasing Power Parity principle (PPP) was enunciated by a Swedish economist, Gustav Cassel in 1918. consort to this theory, the price levels (and the changes in these price levels) in dissimilar countries determine the exchange rate of these countries currencies. The basic article of faith of this principle is that the exchange rates in the midst of various currencies take a hop the purchasing power of these currencies. This tenet is base on the Law of One Price.... It also makes a few additional assumptions. No exercise cost in the foreign currency markets It assumes that there are no costs involved in get or selling a currency. Basket of commodities It also assumes that the same basket of commodities is consumed in the polar countries, with the components organism used in the same proportion. This factor, along with the Law of One Price, makes the overall price levels in different countries equal. Though th e explanation provided by the absolute PPP is very simple and easy to understand, it is difficult to streamlet the theory empirically. This is due to the fact that the indexes used in different countries to measure the price level may not be comparable due to-- the indexes being composed of different basket of commodities, due to different needsand tastes of the consumer.-- the components of the indexes being weighted differently due to their comparativerelevance,-- different base years being used for the indexes. out-of-pocket to these reasons, these price indexes cannot be used to evaluate the validity of the theory.The relative discrepancy of PPP The absolute form of PPP describes the link between the spot exchange rate and price levels at a accompaniment point of time. On the other hand, the relative form of PPP talks about the link between the changes in spot rates and in price levels over a period of time reflect the changes in the price levels over the same period in the concerned economies. Relative PPP relaxes a number of assumptions made by the Law of One Price and the absolute PPP.These are Absence of transaction costs Absence of transportation costs Absence of tariffs. The relaxation of these assumptions