Lecture 1

This lecture will discuss trade theory basics: the supply and demand model and producer and consumer surplus. There is a strong interlinkage between international business and international economics, which is why economics is usually a big part of business programmes. It is very important to also learn about international economics because by operating globally, firms are affected by several matters that are related to economics (e.g. exchange rate fluctuations).

Globalization can be related to different concepts, because everyone has different perceptions of what it is:

• Economic: e.g. rise of global markets, international capital flows

• Cultural: The homogenization of cultural values (e.g. more people speaking English and the American way of life, which is highly promoted by movies made in Hollywood that are shown all over the world). We see other dimensions of this cultural aspect that seem to more and more homogenized.

• Geographic: Compressed time and space (more airspace transportation instead of train/car). It is being easier to connect with other people, as the world seems to have become ‘’smaller’’.

Furthermore people like to talk about institutional globalization, which refers to the idea that institutional ranginess, e.g. how laws operate, how they spread and become more similar in other countries in the world. One key driver behind this spreading of institutional arrangements has to do with the rise of large firms. Good governance is an example of this (e.g. when the world bank takes over development programmes in third world countries).

We can also think of the political dimension of globalization. Nation-states are becoming relatively less important, whereas some large operating organizations/firms have gained more power and influence on determining what is happening in the world.

To some extent, the two world wars decreased globalization a lot (at first the world was already quite globalized, as there was quite a lot of international trade already) and only after the 70s globalization really ‘’took’’ of, which is reflected in the large increase of international trade. The US is a net importer, so they import more than what they export (a trade deficit). Even though the us has a trade deficit, this is not the case for all countries (e.g. they export more to the Netherlands than what they import).

In the world as a whole, trade is always balanced. So trade deficits have to be balanced out by trade surpluses.

Another dimension of globalization is rising capital mobility. One of these factors is foreign direct investment (FDI). Once again, the two world wars had an impact on FDI and also only after the 1970’s FDI really increased rapidly.

We see more and more production processes being broken down, (globally fragmented production processes), meaning that firms assemble the different parts of the product in different countries. An example of this is the apple iPod.

FDI is a type of investment that is long term and entails a lot of control. It differs from foreign portfolio investment which refers to the passive holdings of securities and other financial assets. In flows is the money that countries receive from another country and outflows is the amount of money that countries send to other countries. As for outflows, the investors are mostly from developed countries.

The supply and demand model is a very simple model, which everyone should already comprehend the basics of. The demand curve shows how many products people want to purchase in relation to price. So the demand curve has a negative slope. The price elasticity of demand reflects how the demand of a product changes in relation to price.

Low elasticity  steep demand curve
High elasticity  flat demand curve

We can use the demand curve to assess the surplus/benefit of a product in a market.

The product price is the key determinant of how much of a product producers are willing to produce and sell. Similar to the case of the demand curve, we can also determine the elasticity of supply. In this case:

Low elasticity  steep supply curve
High elasticity  flat supply curve

We can use the supply curve to assess the surplus/benefit of a product in a market.

If we put the supply and demand curve together, we can determine market equilibrium.

The consumer effect refers to the idea that when there is a lower price, more of the good can be consumed. (Welfare gain due to increase in quantity consumed). The producer effect is the welfare gain due to shifting to cheaper foreign producers.

The import demand curve shows you basically how many units a country wants to import at different price levels. The price levels have to be lower than your autarky price. The export supply curve shows you basically how many units a country wants to export at different price levels. The price levels have to be higher than the autarky prices.

Lecture 2

One of the important theories in international trade that deals with the question of what types of products should we be trading is the classical trading theory, and today we will discuss two important models relate to this.

Countries benefit from free trade, and we will look at which products are traded. There are three models related to this: Absolute advantages theory (Adam Smith), The Comparative advantage model (Ricardo) and the Factor Endowments model (Heckscher-Ohlin).

When we talk about the advantages in the production of certain products, we take a closer look at relative prices and opportunity costs, because this shows us which type of product might be better to produce than the other. In order to make things more clear, we can make a production possibilities curve, which shows us how the production of two types of products can be distributed. It is a straight lined curve with a constant slope, and any combination on the line can be produced, next to the combinations ‘’within’’ the line. Yet, the combinations on the line are most efficient. The slope of the PPC is the relative price of a product.

Adam smith thought that trading is not possible in a situation with comparative advantages, and only in a situations where there are absolute advantages. An absolute advantage is what you can do better than anyone else. Therefore he said that produce and export what you can produce more cheaply than any other country  import the rest.

Another name for profit is arbitrage. Profits can be made from the fact that pre-trade (autarky) prices are different. David Ricardo noticed that there is trade based on comparative advantages, and he argued that you should produce and export what you can produce at lower opportunity costs than other countries, and that you should import what involves higher opportunity cost. There are higher consumption possibilities when we allow for trade. Therefore, specialization according to comparative advantages is efficient.

But why should countries specialize according to comparative advantages? The answer to this is that it is cheaper to import a certain product rather than producing it yourself. There is a direct link between the price and labor wages and labor productivity. If the wage ratio is in the calculated range, it is mutually beneficial to trade.

Does productivity then matter? Yes it does!! Labor productivity determines the level of wages. Therefore countries with higher productivity will be richer.

When a country has a competitive advantage over another country, it is more productive. The absolute level of productivity is not relevant for trade. It is more important to take a look at productivity in one sector relative to other sectors and relative to other countries (comparative advantage).

There are several limitations to the Ricardo model, as his theory predicts complete specialization, whereas in reality no country in the world is fully specialized. He also assumes that marginal costs are stable, which is not true.

The Heckscher-Ohlin model assumes that marginal costs are not stable, resulting in a bow-shaped PPC. Then we can ask ourselves, how much a country should produce. It depends on the relative price. What about the consumers in the market? We can show the demand in a market in the indifference curves, they indicate the combination of different goods that yield the same level of utility. Ones that are further up to the right yield a higher utility. Then, how much will consumers buy? It all depends on how much money people have available and the relative price of a good. The budget line shows how much people have available and the slope shows the relative price of a good. The market equilibrium is where the PPC is the same as the IC. The autarky price is given by the slope in this point, and the highest utility is given in the production constraints. This is the situation without trade.

We know that trade changes relative prices. So in a situation where there is international trade, the new price line (international relative price) determines the production and consumption point. Trade leads to an expansion of production of the now more expensive good and an expansion of consumption of the now cheaper good. The excess production is exported and the excess demand is imported (slide 42 in the PP). Trade allows a country to move to a higher indifference curve, meaning that people can consume more than could be produced without trade. The terms of trade determine the gains from trade, so a higher price of exports mean that you can buy more imports  resulting in a larger gain from trade. Additionally, total production of each product increases.

So what determines the trade pattern? In general, differences in prices are a result of:

• Differences in production conditions  ricardo model

• Differences in demand (indifference curves)

• Differences in factor endowments  Heckscher-Ohlin model

• Differences in factor intensities.

All in all, the Hecksher-ohlin model assumes the following:

• Technology is identical across countries

• Different factor intensities of production

• Different factor endowments of countries

Additionally, this model assumes that countries export the product that uses their abundant product more intensively. The model also assumes that all firms are equally productive, yet they differ in their factor endowments.

Lecture 3

The key thing that we have to understand is what happening between prices in two countries. Otherwise we cannot understand the welfare effect. When there are two types of product, e.g. wheat (land intensive) and cloth (labor intensive), and wheat can be produced more cheaply than cloth in the US and the other way around in china. The US will trade wheat and China will trade cloth. When trade opens up, more wheat and less cloth will be produced in the US, and less wheat and more cloth will be produced in China. Therefore, the landowners that produce cloth in the US and the landowners that produce wheat in China will lose, because the prices of these two products have been driven down, whereas the prices of wheat in the US and cloth in China have been driven up.

So in the short-run, trade increases the relative price of the product in which a country has a comparative advantage, so the product that they export. Naturally then, the export-oriented sector will grow and expand, whereas the import-competing sector declines/decreases. Last, the factors of production that are used in the export-oriented sector will profit from free trade, whereas the factors of production that are used in the import-oriented sector will not profit from free trade.

In the long-run however, we have to keep in mind that wheat was land intensive and that cloth production was labor intensive. Because in the US the production of wheat increases and the production of cloth decreases, this has to be taken into account because: because cloth is labor intensive, for every unit of cloth sacrificed, the supply of labor increases relatively fast whereas land increases very slowly. Because wheat is land abundant, for every extra amount of wheat produced, more land is needed than labor. This is also called the Stolper-Samuleson Theorem. He said that the relative price of the exported good increases, and that the returns to the factor used intensively in the export-oriented sector will increase, whereas returns to the factor used intensively in the import-competing sector will fall.

So in the long run, production factors are mobile across sectors within a nation. Factors are likely to move to the export-oriented sector because factor earnings are higher, and this will continue until factors are paid the same in all sectors.

Factor-price equalization (also called FPE) assumes the following:

• Equal production technologies

• Both goods are produced in both countries

• No transport cost

Therefore, free trade would then lead to the following:

• Equal product prices (e.g. wheat or cloth)

• Equal factor prices (e.g. wages or rent)

Yet, in real life situations, international factor prices are not the same, but there is still evidence for convergence. Therefore we do not really this type of situation in the world, because there is no perfect free trade.

The Lerner diagram is pretty much an alternative for displaying the workings and price effects of the earlier discussed Heckscher-Ohlin model. This is called the Lerner Diagram. An An advantage of this diagram is that price effects are visible. Yet, a disadvantage is that the demand side and volumes that are being traded are not visible. There are two elements to this Lerner Diagram: the Isocost line and Isoquant. Note: the Lerner Diagram is relatively difficult to understand. The lope of this line is: –w/r

The isocost line shows all production factors such that total production costs are constant. This implies that higher isocost lines indicate higher costs. The second element is the isoquant, which shows all production values such that the production value is constant. Once again, higher isoquants indicate a higher value. Isoquants are not straight-lined, they look pretty much like indifference curves. An increase in the product price shifts the isoquant line downwards and the other way around. The slope of this line is: 1/p

In the next part of the lecture, the ‘’practical’’ side of the Lerner diagram was discussed with the help of many graphs and diagrams in order to explain this topic. Therefore, in order to fully comprehend this topic, please refer to the lecture slides of the third lecture that was held on 28-4-2015. For this reason, this part is not fully discussed in these lecture notes.

Lecture 4

There are several issues that come with free trade. For example, there might be trade barriers in many forms and sizes that prevent firms from engaging in trade. Today the focus will be on welfare and the distributional effect of trade barriers, and the pros and cons of trade protection.

There are several effects of trade barriers. And these effects will be discussed for small economies and large economies, as tariffs have different effects on different types of economies. In a small country, the domestic price of the imported good increases relative to the world price, and creates tariff revenue for the government. Additionally, if the country that imposes the import tariff is small, the reduction in import demand in the world market is negligible and the world price is not affected.

Whenever a tariff is imposed on a product, the producers will gain surplus and the consumers will lose surplus, because of the higher price. The government is going to gain from imposing the tariff, because they gain tariff revenue. The loss as a result of imposing this tariff, is also referred to as a deadweight loss.

To summarize, imposing a tariff increases the domestic price of a product, and results in a fall in the consumer surplus and a rise in the producer surplus, and in a fall of the quantity imported. The tariffs generate government revenue, and cause a net loss for the importing country.

The production effect is a welfare loss from replacing low-cost foreign production with high-cost domestic production and is the sum of production price differences for the units that are replaced by domestic production.

The consumption effect of a tariff is basically the welfare loss as a result of reduced consumption. It is the sum of differences between the willingness to pay and the pre-tariff price for the units eliminated through the tariff.

The effect of a tariff in a large country is a bit different. If the country that imposes the tariff is large, the reduction in demand for imports will lower the world price, and the country that imports and the country that exports are both affected by the tariff. Once again, the consumers will lose and the producers and the government will gain. Sometimes it can be relatively hard to tell whether the overall welfare gain is positive or negative.

In the exporting country however, the consumers will gain surplus and the producers will lose from the reduction of the price of the product. However, the positive surplus of the consumers is smaller than that of the producers, the overall net gain is still negative.

To summarize, in a small country, tariffs reduce aggregate welfare, and in a large country, national welfare may increase (nationally optimal tariff). The nationally optimal tariff is the tariff that would optimize the national welfare. In a large country, imposing a tariff may increase national welfare. For the world as a whole, the welfare effect of a tariff is always negative.

A non-tariff barrier are for example import quotas and product/process requirements. Quantity restrictions usually do not comply with WTO regulations, however, non-tariff-measures to.

An import quota a restriction on the quantity that is being imported by a country. If the quota Q is imposed, this increases the supply of the amount of goods that are available to domestic consumers by the amount Q. In a small economy, when import quotas are imposed, the consumer surplus will decrease and the producer surplus will increase.

When a large country imposes an import quota, the domestic supply will equal S+Q. In this type of economy, the consumer surplus will decrease and the producer surplus will increase. The government will also experience a gain.

To sum up, trade barriers can have different shapes and sizes, and we have seen that free trade causes winners and losers. Most often, trade barriers produce welfare losses. Then, why do countries still impose trade restrictions?

An argument why trade barriers might be good is that under certain circumstances, welfare effects might be created in different sectors. Tariffs and non-tariff measures can increase employment and production in the import-competing sectors, increase government revenues, decrease domestic consumption of the imported good and change the income distribution. Hence, other government policies are very often more efficient and prevent retaliation, meaning that other countries will also respond by setting trade barriers which might result in a ‘’barrier’’ war.

Another reason fort trade barriers is that a lack of government revenue might lead to inadequate supply of public goods, and import tariffs may be a valid policy choice if tariffs are a crucial source of government revenue. Therefore, the benefits of better public goods provision might outweigh deadweight losses from tariffs.

A third argument is that by restricting trade we are changing the income distribution. But, direct income transfers are more efficient, and can achieve the same income distribution without price distortion.

The infant industry argument states that protection from import competition gives the domestic industry time to become more competitive.

Lecture 5

Last week we came to the conclusion that trade barriers always result in a negative result for the Rest of the World. Today we will focus on the effects of trade unions and trade embargoes. We will discuss different types of trade blocs, the effects of trade unions, namely trade creation and trade diversion, and the effect of trade embargoes.

A trade bloc has several definitions. It means for example that different types of countries agree to lower or remove trade barriers among themselves, but keep barriers against imports from non-member nations. A group of countries decides to give preferential treatments towards each other, but not towards other countries. In fact, this actually violates the WTO rules, especially when a country uses the MFN (most favored nation principle), which means that concessions given to one foreign nation must be given to other nations as well.

However, in some cases trade blocs are allowed. For example among industrialized countries, when the average external tariff does not increase, when there is preferential treatment given to developing countries, or when they are regional blocs.

There are different types of trade blocs:

• Free-trade area (for example NAFTA). This implies that there are no trade barriers among member states, and that there are separate national barriers against outsiders. A problem within the free-trade area can occur when there are different tariffs for all member countries, because then non-member countries will export their products to the member-country with the lowest export tariffs. This results in a very unfair situation where one country gets (almost) all trade and others don’t.

• Custom union (for example MERCOSUR). This type implies that there is no trade barrier among member states, but that there is a common set of tariffs against outsiders.

• A common market, which is a custom union where there is free mobility of labor and capital among member states. A good example of this is the EU.

• An economic union, where there is free mobility of goods and factors of production, and where there is a unification of all economic policies. An example of this type of trade bloc is Belgium and Luxembourg working together.

What we see is that the removal of trade barriers among member countries logically creates more trade. Depending on who is part of the trade union, trade may be diverted away from more efficient producers.

Trade creation  gains from forming a trade union

Trade diversion  loss from forming a trade union

There are several effects of trade creation and trade diversion. The effect of trade creation is a welfare gain from creating new trade, namely gain from extra consumption, and gains from replacing high-cost domestic production with lower-cost partner production (remember: production effect). The effect of trade diversion is a loss from replacing low-cost outsider production with higher-cost partner production.

If we compare the size of the trade creation effect and the trade diversion effect, we can say that the net welfare effect of forming a trade union depends on whether the gains from trade creation exceed or fall short of the losses due to trade diversion.

In addition to welfare gains, there are also other benefits from forming a trade bloc. For example, there is a possibility to create a larger market, therefore firms have the possibility to exploit better economies of scale, and the country might attract FDI. Furthermore, there is the opportunity of increased competition, as a result of firms being forced to lower their prices, and firms being forced to produce more cost-efficiently.

Trade embargoes are unilateral or multilateral decisions that can be made in order to make trade with another specific country extremely difficult or even impossible. It is a discriminatory policy that blocks trade.

Whenever a trade embargo is imposed, it usually reduces export in the ‘home country’. As a result, consumers gain and producers lose. The net welfare effect is a loss. This is the effect of a country engaging in an embargo. The effect in non-embargoing countries is different. In this case, when the embargo increases the world price, consumers lose whereas the producers gain, which is opposite to the embargoing countries. The net welfare effect is a gain. There is also a different effect in a target country. In this case, when the embargo is imposed and the price increases, consumers lose and producers gain. The net welfare effect is also a loss, yet, the loss is larger.

What we can see is that the embargo decreases welfare in the embargoing countries, and in the target country. It increases welfare in the non-embargoing countries. But: the world as a whole will experience a decrease in welfare.

If the net welfare gain in the whole world is negative, why would countries still impose them? Well, the welfare reductions can be relatively little when compared to other non-monetary benefits. Additionally, a decrease in welfare might be small compared to the welfare losses in the target country.

Keep in mind, that trade embargoes can also fail. And this failure is likelier when the export supply curve of the embargoing country is very steep, and when the import demand curve of the target country is very flat. Where large nations have relatively flat export supply curves, smaller nations have relatively steep import demand curves. Therefore embargoes that are imposed by large countries onto small countries are likely to succeed.

Lecture 6

We need imperfect competition for various reasons. First of all, the classical trade theories predict that trade is driven by differences in relative prices and/or comparative advantages. This would imply that a country should export and import different products. This is also referred to as inter-industry trade. However, over time it has become evident that in reality there is substantial trading among similar countries, meaning that countries export and import similar products. This is also referred to as intra-industry trade (e.g. cars, cellphones and make-up). In particular over the past 40 years we see this type of trade happening a lot, and we can use the theories of imperfect competition to explain this.

As mentioned before, intra-industry trade means that we trade within a given industry, meaning that counties import and export at the same time products that are very similar to one another. It can be calculated as the following :

IIT: total trade in given industry – net trade in that industry

The importance of IIT is higher in the non-food sector and has increased over time. Additionally, the IIT share is relatively larger in developed economies. A reason for this is that poorer countries are more dependent on food products (primary goods), rather than non-food products. We see that most of the IIT is driven by product differentiation (for example different types of cars).

Most economists like to use the Grubel-Lloyd index. It captures the extent or the importance of IIT relative to total trade. You take the total trade in an industry, you subtract the net trade in that industry, and you divide that by total trade.

So: GL_i = (total trade – net trade) / total trade

In an economy where exports and imports are the same, GL is 1. It tells us that all trade within an industry is IIT. It is the most extreme value the GL index can get. When there is a situation in which there are only exports and no imports (or the other way around), GL will be 0.

We need imperfect competition to understand the theory of Intra-Industry Trade. Imperfect competition means that a firm has some market power (meaning that it can influence the price of its products). The main underlying cause for this is that there are increasing returns to scale. This means that when production increases, the average cost of production will fall, and the other way around. This means that a producer can influence the price of its products. The main reason for falling average costs is the presence of fixed costs at the firm level.

We know that under perfect competition firms cannot influence the prices of their products, as these are determined by supply and demand. Therefore the marginal revenue will equal the price in the market. When firms maximize profits, they equalize marginal costs with the marginal revenues. With fixed costs, firms will make a loss when they charge a price that is equal to the marginal costs.

There are several models that are related to imperfect competition: monopoly, duopoly/oligopoly and monopolistic competition. When there is a domestic monopoly, in the absence of foreign competition, the domestic firm will make a profit that equals ABDE (refer to slide 9 of lecture 6). When there is an identical foreign firm, this firm will take the quantity that is produced by the domestic firm as given. Therefore it exports its products to the residual consumers in the domestic market. As a result, countries will start trading identical goods with one another.

When there is monopolistic competition, there is a very large amount of firms that all produce goods that are similar to one another. There is free exit and entry from and into the market. Additionally, every firm in the market is a monopolist for the specific variant of the product that it is offering. Entry of new companies decreases demand faced by each firm and correspondingly the marginal revenue  reduction in profits of each firm.

In monopolistic competition with trade, foreign firms will offer varieties that are not currently offered by domestic firms. What happens now, is that if the domestic country opens up to trade, customers will wish to buy products that only the foreign firms offer. This is also the same for the customers in the foreign country, who might now wish to buy products that are only offered in the domestic country. What happens is that part of the domestic consumers will switch to foreign suppliers and the other way around. Therefore there is two-way trade in similar products, and total sales and prices are unaffected by trade in this case.

Also, as a result, opening up to trade will attract new customers that earlier on did not buy anything and also encourages new firms to enter the market (resulting in more varieties). With more firms in the market, and more consumers with more price-elastic demand, the demand curve will shift down and become more flat. This will lead to lower prices and therefore a decrease in profits. Some firms will therefore exit the market until again all firms will make no profit anymore. Consumers will benefit from lower prices and increased variety.

All in all, we find that there are large differences across firms within industries. Not a lot of firms engage in international trade.

In a model with firm heterogeneity, every firm offers a unique variant of a product and behaves like a monopolist. We assume that there are no fixed costs. The firms that are more productive will sell larger quantities, charge lower prices and make larger profits. Trade will make the demand curve more flat and will shift down.

Lecture 7

As for accounting principles, each transaction is reported twice, once as a credit and once as a debit item. Credit items are transactions that lead to an entitlement to receive a payment from a foreigner. So they make sure that you as a country receives money from abroad. It creates demand for the domestic currency/supply of the foreign currency. Debit items creates a demand for the foreign currency/supply of the domestic currency, and creates an obligation to make a payment to a foreigner.

In the balance of payments, we have different types of accounts. There is for example the current account, where we record the following:

• Exports of goods and services

• Imports of goods and services

• Income received from foreigners

• Income paid to foreigners

• Unilateral transfers, these are basically gifts and remittances that the government makes to foreigners. Considered a debit item.

Another type of account is the financial account/capital account. A capital outflow is the situation which we are buying foreign financial assets, so the country leaves our country, and it is recorded with a negative sign. So there is an increase in domestic holdings of foreign assets and a decrease in foreign holdings of domestic assets. This can be the result of, for example, purchasing foreign assets or foreigners selling their domestic assets. Pay attention that the only thing that is being recorded is the principal value of the financial assets that are traded.

Capital import, which is noted with a positive sign, is an increase in foreign holdings of domestic assets or the reduction in domestic holdings of foreign assets. It is the results of foreigners buying domestic assets and selling foreign assets.

There are also other things that can be recorded on the balance of payments account:

• Net transfers of assets

• FDI

• Portfolio investment

• Other investment

• Change in reserve assets held by central banks (recorded in the official reserves account).

We know that the value of the current account and the financial account has to be zero. So: CA + FA = 0 -> CA = - FA

We can also state the following:

Current account balance = net foreign investment (I_f)
I_f = Domestic savings – Domestic investment

This leads to the following conclusions:

CA > 0 -> I_f > 0 -> The country is a net lender
CA < 0 -> I_f < 0 -> The country is a net borrower

The official settlement balance is the balance of current account and private financial transactions. It can be calculated as follows:

B = CA + (FA – OR) -> CA + FA = 0 -> B + OR = 0

If the official reserves account is negative, this means that central banks must have received its holdings of foreign assets. The opposite counts when the official reserves account is negative.

An exchange rate is basically nothing else than the price of one currency expressed relatively to another currency. The exchange rate between two currencies can be expressed in two ways:

• Value of the Euro in terms of the $

• Value of the $ in terms of the Euro

In the textbook, the definition for the nominal exchange rate being used, is that it is the ‘’value of the foreign currency in terms of the home currency: HCU/FCU’’

When there is an increase in the exchange rate, this means that there is an appreciation of the foreign currency (and therefore a depreciation of the home currency): therefore you will need to pay more HCU for one FCU.

The (nominal) exchange rate: is the price of one currency in terms of another. The price of one currency can be expressed in relation to a lot of other currencies. The effective exchange rate is the weighted average of the values of a country’s currency relative to various currencies.

The spot rate is the price of buying or selling a currency at this moment. The forward rate is the price of buying or selling a currency at a specific pre-defined rate in the future. The nominal exchange rate is the relative vlue of two currencies, whereas the real exchange rate is the relative value of two currencies adjusted for differences in product prices in the two countries.

When there is an increase in the real exchange rate, the foreign products have become relatively more expensive, and when there is a decrease, the foreign products have become relatively less expensive. Movements in the real exchange rate imply changes in the international price competitiveness of country’s products.

Exchange rate fluctuations are partially caused by trade. The law of one price implies that a product that is easily and freely tradable (like apples) should have the same price everywhere, in order that there are no international arbitrage opportunities.

Purchasing Power Parity (PPP) is kind of the same as the law of one prices, but instead of only one type of product, it is related to larger bundles of products. It holds when the exchange rate between two countries is equal to the ratio of their prices.