The law of one price is the basis of purchasing power parity theory. It was proposed by the famous Swedish economist Cassel in 1918, and in 1922 he elaborated theoretical system of purchasing power parity in the book “The currency and foreign exchange after 1914”. The doctrine is that, as long as the same basket of goods and services, in the absence of impacts of tariffs and transport costs, its costs are same in any country, which means that the value of a currency depends on its own purchasing power. The basic proposition of the theory holds that the determinant of the exchange rate is the price level. Purchasing power parity is divided into absolute purchasing power parity and relative purchasing power parity. The former refers that exchange rates between two countries should be equal to the ratio of the relative price level, and the latter refers that the change in exchange rates between two countries is equal to the relative price changes in the level.
Traditional starting point for all the analysis of purchasing power parity is the Law of One Price. Law of One Price is a theory about the relationship between currencies and price levels in different countries. It is based on the following assumptions: Two countries can only produce tradable goods and these goods are homogenized; there are no trade restrictions, such as tariff barriers or transaction costs; no capital mobility; full employment level in the economy and the money market system works well; sufficient arbitrage opportunities exist. Under these conditions, the law of one price was established, formally: