Management of International Business Finance Essay

Management of International Business Finance - Essay Example we can conclude that as long as the relative price of two currencies is flexible, it will then adjust to equal the ratio of their price level. Even if this type of adjustment does not take place, the ratio of price levels can give us a reference point from which we can assess if a current exchange rate is under or over evaluated in relation to its PPP level. For the OECD the simplest way to calculate PPP is to take into consideration a same product within two countries. It uses a liter of Coca-Cola to illustrate the example. In France, one liter is worth 2.3 euros where in the United States the same liter costs 2 dollars. Therefore the PPP (calculated as a ratio) is 2.3/2 which equals 1.15. The result can be interpreted as follows: for every dollar which is spent in the United States to purchase a liter of Coca-Cola, in France, it is necessary to spend 1.15 euros to receive the same quantity and quality of Coca-Cola. As the OECD points out, the PPPs are not only calculated for individual products but also for group of products. One of the most famous PPP index is the Big Mac PPP. Used as a vulgarization for a greater part of the population to understand the issues regarding PPP, it represents the exchange rate that would leave a burger in any country costing the same in America. (See Appendix 1) (The Economist â€Å"Food for Thought† May 27th, 2004.) The most important and certainly the best known research made on the failure of PPP in the long run is the â€Å"Balassa-Samuelson† effect, work of Balassa (1964) and Samuelson (1964) The effect states that if high-income countries hold a more important relative productivity advantage in the production of traded goods, they will consequently produce these goods more cheaply. Starting from the hypothesis that the law of one price – abstracting from complicating factors such as transportation costs, taxes, and tariffs, the law of one price states that the price of any particular good that