Handbook of Exchange Rates

7.1 Introduction

In this chapter, we provide a discussion of the law of one price (LOP), the basic building block of purchasing power parity (PPP). The LOP relates to the common-currency prices of similar goods at a disaggregated level, postulating that similar tradable goods, once their national prices are expressed in a common currency, should sell for the same price across different international locations. Aggregating across different tradable goods and services in a sector and then across different sectors, one obtains that the resulting baskets of tradable goods should trade at the same price: this is the notion of PPP in tradable goods. Further aggregating across other goods and services, including nontradables, leads to the conventional PPP hypothesis, which states that national price levels should be equal when expressed in a common currency.

While several surveys exist on PPP, this chapter mainly focuses on internationally tradable goods and services, rather than broad baskets of goods and services, which also include a substantial nontradable component. Specifically, the objective is to understand the properties of deviations from the LOP applied to internationally tradable goods or sectors, on the basis of the existing empirical evidence published in the leading academic literature. To anticipate our conclusions, we will show that a careful reading of the literature suggests that the LOP holds over long periods of time for the relevant tradable goods and services, and ...