Foreign exchange refers to two different things. The first is currency claims expressed in the equivalent value in foreign money. The second is actual transactions involving the conversion of money of one country into that of another.

Foreign exchange is necessary because different countries have different monetary units. One country's currency typically cannot be used in another country. The determination of the price at which the currency of one country will be or should be exchanged for that of another country is the basis of this and many other essays and studies.

Foreign exchange is a commodity, and its price fluctuates based on supply and demand, like any commodity. This is not the place for a complete discussion of supply and demand as relates to foreign exchange, but for our purposes, we will assume that supply of and demand for a country's currency moves along with the supply of or demand for that country's products or the products of its trading partners. For example, if one country buys many more goods from its neighbor than its neighbor buys from it, the balance of payments at the end of the year will cause its neighbor's

At its simplest formulation, PPP is also called the law of one price (LOP). This formulation contains several caveats. First, LOP assumes that there are no transaction costs involved in buying a commodity in one market and selling it in another. Obviously, in a situation involving substantial transaction costs relative to the cost of the commodity in question, LOP will be empirically meaningless. Second, for this formulation to hold true, there must no barriers to trade. This would include prohibitions, tariffs, taxes, and quotas. Lastly, and perhaps most obviously, is that we must be comparing homogeneous goods.

P*(i,t) = the current foreign currency price of commodity i

P*(t) = an index of a subset of goods and services in foreign currency

Mathematically, the absolute version of PPP can be expressed thus:

that lay outside our discussion of PPP, such as goods that are not available in some area, obviously not all of it is. For foreign trade to occur, there has to be a price differential high enough at the destination sufficient to cover shipping, tariffs, financing, insurance, and any other costs involved in transferring goods from one location to another. Not only must price differentials exist, but they also must remain for trade to persist.

Some common words found in the essay are:
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