The Purchasing Power Parity (PPP) theory was developed by Gustar Cassel. According to this theory the rate of exchange between two currencies must be determined on the basis of purchasing power parity. In this theory we get two version.
So friends, in today’s article we are going to know about purchasing power parity theory of exchange rate. So let’s discuss in details.
Absolute Purchasing Power Parity (PPP)
The absolute Purchasing Power Parity theory is closely related to the low of one price which means that a product that is easily and freely traded in a perfectly competitive global market should have the same price everywhere.
The law of one one price proposes that the price of the product measured in domestic currency (P) will be equated to the price of the product measured in the foreign currency (Pf) through the current spot exchange rate (e). Symbolically,
P = e. Pf
e = Spot exchange rate,
Pf = Foreign currency.
Relative Purchasing Power Parity (PPP)
The relative Purchasing Power Parity between two currencies states that the percentage change in the bilateral exchange rate is equal to the difference in the percentage change in the rational price level, over any given period of time.
It means while the absolute PPP is a statement about absolute prices and exchange rate levels, the relative Purchasing Power Parity is a statement about price and exchange rate changes over time.
The equilibrium exchange rate is determined on the basis of following formula –
ER = Er x Pd/Pf
ER = Equilibrium exchange rate,
Er = Exchange rate in the reference period,
Pd = Domestic price index,
Pf = Foreign countries price index.
Let us assume that in the base year the exchange rate was $1 =
Z5. The price index in India has doubled from 100 to 200 while there is no inflation in America and its price index remains at 100. Thus the new equilibrium exchange rate in the current year will be –
ER = Er x Pd/Pf
⇒ $1 = 25 x 200/100/1oo/100
⇒ $1 = 25 x 2/1
⇒ $1 =
Criticism of Purchasing Power Parity (PPP) theory
The purchasing power parity theory of exchange rate has been criticized on the following grounds –
• The theory uses price index number to measure the changes in the equilibrium rate of exchange. But in reality the price index number is suffering from several limitations.
• This theory is based on the unrealistic assumption of free trade. But in reality international trade is not free from barriers.
• This theory does not explain clearly the determination of demand for and supply of foreign exchange.
• Another defect of the theory is that it ignores the impact of changes in the exchange rate on the prices. Thus this theory is an one way traffic.
So friends, this was the concept of purchasing power parity theory of exchange rate determination. Hope you get the full details about it and hope you like this article.
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