Define the Law of One Price and Purchasing Power Parity

1. Define the Law of One Price and Purchasing Power Parity.

LOOP (LAW of one price) explains that if no trade frictions e.g. tariffs exist and there is free competition in the market than same goods in different countries should be sold on same prices when express common currency. This law is the basis of purchasing power parity theory.  Purchasing Power Parity on the other hand evaluates the economic variables of different countries. In this law irrelevant exchange rate variations have no impact on the comparisons.

1. What spot exchange rate would establish the Law of One Price in terms of champagne? What is this FX rate called?

If the FX rate of USD-BRL becomes 3.33 than the law of one price will be established with reference to champagne.  This FX rate will be called nominal exchange rate. Nominal exchange rate shows how much foreign currency can be converted into local currency.

3. If the current spot FX rate is BRL 3.5709/USD (December 01, 2016) what is the real exchange rate? Is the BRL overvalued or undervalued?

BRL 3.3333/USD would be the real FX rate. Real exchange rate is comparing the price of the products that are same in both nations. As the spot rate is BRL 3.5709/USD then it can be said that BRL is undervalued currently.

4. Inflation is expected to run between 4.5% in Brazil (official target rate of the Central Bank for 2017) and 5% (OECD forecast for 2018). In the US, the OECD expects it to run at about 2.2% in the next year. What is a good estimate of the future BRL/USD spot rate?

The future spot rate of BRL/USD is evaluated as follows: