THE LAW OF ONE PRICE, PURCHASING POWER PARITY AND EXCHANGE RATES: SETTING THE RECORD STRAIGHT

Exchange-rate economics is filled with puzzles. The asset approach has failed and without it most open-economy models are built on sand. Conventional wisdom rejects the Law of One Price and views Purchasing Power Parity as useful at best in the long run. We show for the first time how recognizing differences between retail, wholesale and auction markets, and recognizing that trade involves time in transit, helps solve the puzzles and provides a theory of exchange rates using auction markets for assets and commodities. We also restore the Law of One Price and Purchasing Power Parity to the status of “not rejected”.