Purchasing Power Parity Theory | TYBCOM Business Economics Semester 6

Purchasing Power Parity Theory

Introduction/ Meaning:

• Purchasing power parity (PPP) is an economic theory of exchange rate determination. It explains that the price levels between two countries should be equal. if they are measured in a common currency.
• PPP theory explains the determination of long-run equilibrium exchange rate based on the relative price of two countries.
• It originated in the School of Salamanca in the 16th century. The concept was developed into theory by Gustav Cassel in 1918.
• For instance, a product of the same quality and size is produced both by India and China. As per the theory, if measured in common currency the price of the product in India will be equal to that of China.
• The Theory has two versions: (1) Absolute version and (2) Relative version

Assumptions of Purchasing power parity:

• There are no Trade barriers
• Same basket of goods to calculate the Price index
• Identical Goods
• All the prices should be indexed to the same year
• Law of one price

Absolute version of Purchasing power Parity

• According to the absolute version of the PPP theory, the exchange rate will be determined at the point where the internal purchasing powers of the two currencies become equal.
• The identical basket of goods in two different countries must sell for the same price when expressed in the same currency.
• The exchange rate is equal to the ratio of the price index of the basket of commodities in the home market to the price index of the basket of commodities in the foreign market.

Criticism

• Purchasing power of money cannot be measured in absolute terms because the price changes and fluctuates.
• Different quality of goods and different countries can not be measured because quality may differ.
• Difficult to select a basket of goods or commodities due to different preferences and different lifestyles.
• Problem associated with index numbers
• No direct and precise link between the purchasing power of currencies f two countries and the exchange rate.
• Capital account transactions are neglected.

RELATIVE VERSION of Purchasing Power Parity

• The relative version of the Purchasing Power Parity theory is propounded by Gustav Cassel as a means for measuring changes in the equilibrium exchange rate.
• The relative version of the PPP theory states that the changes in the equilibrium rate of exchange will be determined by the changes in the ratio of their respective purchasing power.
• The primary focus is the comparison between the past (base rate) equilibrium exchange rate with the current equilibrium exchange rate.
• Change between two equilibrium rates is primarily due to changes in the internal purchasing power of the two currencies over a period of time.

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