Purchasing Power Parity
Swedish Economist Gustav Cassel set out in the early 1920s to determine a true exchange rate between nations at various price levels when the gold standard broke down at the outbreak of World War I. Exchange rates were allowed to free float, causing an anomaly never understood—inflation. The Law of One Price asks the question how much does a tradeable good in nation A cost in relation to nation B? The Law of One Price says goods expressed in one price in one market should sell for the same price in another market or an arbitrage would exist to equalize prices.
Suppose a bushel of wheat costs $15 in the United States and $30 in Japan. The spot price of wheat in United States divided by the price of wheat in Japan is equal ...
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