Purchasing Power Parity (PPP) is the exchange rate determination used to
compare the average cost of goods and services between countries. What this theory implies is that the actions of importers and exporters are motivated by cross country price differences influencing changes in the spot exchange rate. In essences what we have is transactions on one country's current account affects the value of the exchange rate on the foreign exchange market. The foreign exchange market uses the US dollar exchange. The interest rate parity assumes the action of the investors influences the change in the exchange rate. To understand PPP, I had to break the concept down to a few different components.
Since the PPP is based on the theory and variations of the "law of one price (loOP) it is necessary to understand the loOP theory. "The loOP says that identical goods should sell for the same price in two separate markets when there are no transportation costs and no differential taxes applied in the two markets"(Suranovic, Steven (1997-1999).
So if a video sells for $20 in the US and the same video sells for 150 Mexican pesos in Mexico or converted to US dollars the same video would cost $15 US dollars in Mexico. Since the dollar of price for the price of the video did not match the dollar price in the US the law of One Price does not hold (Suranovic, Steven (1997-1999).
What might happen if the US tourist travels over to Mexico and buys up the CD's and brings them back to the US and sells them for the US market price. A profit would be made. Mexico in turn would increase it sale of the CD because of the laws of supply and demand. It may then increase its prices. The law of...