International Financial Theory on the basis of Empirical Evidence Essay

International Financial Theory on the basis of Empirical Evidence - Essay Example The PPP theory states that there will be price equalization of goods internationally once they are measured in the same currency due to arbitrage forces (Pilbeam, 2006). This theory is based on the law of one price, which states that identical products when sold in different markets will sell at the same price when expressed in common currency. The main assumptions for this law to hold good are the presence of a competitive market structure, absence of transport costs and other barriers to trade (Sarno and Taylor, 2002).There are two types of purchasing power parity; the absolute and relative power parity. The absolute power parity theory states that a rise in the home price level relative to the foreign price level will result in an equivalent depreciation of the home currency against the foreign currency. Relative power parity states that there will be adjustments for the exchange rate by the amount of inflation differential between two countries (Pilbeam, 2006). The main problem w ith the PPP theory is that it does not distinguish between traded and non-traded goods. Many studies have shown that this distinction is important for testing PPP since traded goods are determined mainly by international competition while non-traded goods are influenced by domestic supply and demand conditions (Officer, 1976, 1986). At the same time, some other authors have showed distinction between traded and non-traded goods as unclear (Sarno and Taylor, 2002).The other limitations are the assumptions underlying the PPP theory like perfect competition, absence of transport costs and barriers to trade which are questionable. Further, it is very difficult to find identical products to be compared for testing PPP in different countries (Rogoff, 1996). Thus PPP is theoretically ambiguous and remains and empirical question. Three types of empirical evidence for PPP have been done .They are based on graphical representations, simplistic data analysis and