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Global Financing And Exchange Rate Mechanisms The Big Mac Index

1265 words - 5 pages

Global Financing and Exchange Rate Mechanisms 1
Global Financing and Exchange Rate MechanismsGlobal financing and exchange rates have become an important issue for global business. Extreme increases in the price of oil and other commodities and inflation has led to significant exchange rate risks in today's global markets. The following will analyze purchasing power parity and the "Big Mac Index", explain how purchasing power parity and the "Big Mac Index" are used in global financing operation and their importance in managing risks.In order to understand the relation between prices and exchange rate movement's one must understand the economic proposition known as the law of one price. The law of one price states that, "…in competitive markets free of transportation costs and barriers to trade (such as tariffs), identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency" (Hill, 2009, p. 331). For example, in the text International Business: Competing in the Global Marketplace, 7th ed, the author uses an example which uses the exchange rate between the British pound and the U.S. dollar. If the exchange rate between the British pound and the dollar is £1 _ $1.50, a jacket that retails for $75 in New York should sell for £50 in London. However, if the jacket cost £40 in London which converted is $60 in U.S. currency a trader could purchase jackets in London and sell them in New York while making a profit of $15. The law of supply and demand would demand that the increased demand for jackets in London would increase their price and the increased supply in New York would lower their price in the U.S. and this would continue until the prices were equalized. (p. 331).Purchasing power parityThe Dictionary of Economics published by The Economist defines purchasing power parity (PPP) as, "A theory which states that the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at the rate of exchange are equivalent" (Moffat, 2008). Assuming that the low of one price is correct for all goods and services then the PPP could be discerned from any set of prices. Comparing the prices of identical products and services in different countries would enable one to determine the real PPP exchange rate. In short, the goods purchased in Canada should cost the same as goods purchased in the United States once the exchange rate is calculated; the exchange rate between the two countries should equalize.The "Big Mac Index"The Big Mac Index, introduced by The Economist magazine in 1986, was developed as a way to determine the "true value" of different currencies. Burgernomics is based on the purchasing power parity theory, which states that, "…the exchange rate between two countries should move towards the rate that equalizes the prices of an identical basket of goods and services in each country" (The Economist, 2000)....

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