Today we will be talking about purchasing power parity, which is a theory of exchange rate determination in the long run. If prices of goods in one country are lower than in another (i.e. the real exchange rate is less than one) arbitrage will often take place: goods will be bought in the cheaper country and exported to the more expensive country. The process will go on until price differences are eliminated, i.e.until the real exchange rate is one.
Here is an example. As the Canadian dollar depreciated, grey market exports of cars from Canada to the U.S. has been increasing.
Here is why. A certain car in the U.S. cost $US43 395, and in Canada $Can45 944. As the nominal exchange rate is $0.75, the real exchange rate is - well - something for you to figure out.
Why the purchasing power parity not always works? In class we will discuss several reasons. The article gives another: a concerted action by the manufacturer to prevent arbitrage. Nissan is threatening Canadian dealerships that sell to U.S. buyers with termination.
A car is an unusual product in that it has to be registered and is identifiable. So Nissan's tactic cannot be used for most goods and services. But, by differentiating products across countries (for example by providing only local warranties) manufacturers try to reduce arbitrage.
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