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Discussion 1 summary Business & Marketing Coursework

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Discussion for article, Purchasing Price Parity Debate (pgs 135-149) February 15, 2013 I. What is meant by the law of one price? A. How is this related to international arbitrage? B. What immediate objections hold to this theory? What is the advantage of using a price index for only tradable goods C. What conclusions do you draw from Figure One about absolute PPP? D. What conclusion do you draw from Figure Two about relative PPP? II. What was the state of PPP theory in the early 1970’s? Why and how did this change? A. What is meant by the monetary approach to exchange rates? B. What tests of the monetary approach were done? Why did they look promising? What factors were responsible for these results? C. What is meant with the real exchange rate? What behavior of the real exchange rate lead economists to reject strong versions of PPP? III. What is known about long run PPP? A. How do you test for long run PPP? Why is this only a necessary but not a sufficient test? What results have been found from the literature? 1 B. What is meant by a random walk? What conclusions can be drawn if the real exchange rate follows a random walk? C. What did the early literature find when it came to tests of random walk? Why did the power of these tests affect the result? D. What is meant by a unit root test? What conclusions about prices can be made from the failure to observe a unit root? What results did the early literature find? IV. What was done to increase the power of these tests? A. What steps to increase the power of such tests were unsuccessful? B. Why was it difficult to increase the number of years? C. How did Frankel(1986)? reject the unit root test? D. What have researchers with a larger sample of countries tested? What have they found? How do these studies form a first puzzle? V. What is meant by the second puzzle surrounding PPP? A. What is meant by a half-life? Why does Rogoff think halflifes are too long? B. How can non-linearities explain long half-lifes? C. What is an iceberg cost? What is the motivation of the theory? What does it explain? D. What is a ”threshold autoregressive model?” What is the evidence on these models? VI. What conclusions would you make about the state of PPP research? 2



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Purchasing Power Parity Answers
1 It is a law that holds that the price of internationally traded good should be the same globally once converted into the same currency.
* The Law of One Price acts as an alternative way of solving price disputes over international companies that sells the same product. Therefore, it is an international arbitrage (137).
* Objections to the Law of One Price – Additional charges, for instance, taxes, tariffs, transportation costs and custom duties in one company would not set fair environment for following the law. Price indices can be used to estimate the average price of goods that are tradeable between countries.
* The PPP is neither perfect nor absolute because the correlation between the PPP of the UK and the US are imperfect. Besides, price levels of the US and the UK do not move together even after expressing them in common currency (138).
* The PPP is imperfect because relative depreciation and inflation in the US and the UK do not perfectly correlate.
2 In 1970s PPPs were equal in all countries because the US dollar was convertible to gold and other currencies pegged to it (140). This changed after president Nixon ended the convertibility of the US dollar by devaluing it against gold (141).
* Monetary approach – assumed that the exchange rates of the PPP held continuously and was determined by the interplay of demand and supply of different currencies.
* The test of monetary approach was done by purchasing foreign currencies using the US dollar. It looked promising for the first three years because the dollar was restively stable. It was successful there wasn’t enoug...
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