The Purchasing power parity theory

1. The purchasing power
parity theory
Dr. Geetanjali Diwani

2. Introduction
The Purchasing power parity theory is
said to have been originally
formulated by Wheatlay in 1802 and
later by Blake in 1810.
Gustav Cassel, a Swedish economist,
reformulated the theory and
developed the concept of an
equilibrium rate of exchange in 1920.
Dr. Geetanjali Diwani

3. Statement
The purchasing power parity theory of exchange rate determination states that the
exchange rate between any two currencies equals the ratio of their price level.
This theory asserts that the relative values of different currencies correspond to the
relation between the real purchasing power of each currency in its own country. In other
words, under a free and inconvertible paper currency system, the rate of exchange
between any two currencies is determined by their purchasing power in the respective
currencies. This theory is called the purchasing power theory of rate of exchange.
Dr. Geetanjali Diwani

4. Explanation
For example, if a certain assortment of goods can be had for £1 in Britain and a
similar assortment with Rs. 80 in India, then it is clear that the purchasing power
of £1 is equal to the purchasing power of Rs. 80. Thus, the rate of exchange,
according to purchasing power parity theory, will be £1 =Rs. 80.
Let us take another example. Suppose in the USA one $ purchases a given
collection of commodities. In India, same collection of goods costs 45 rupees.
Then rate of exchange will tend to be: $1=45 rupees.
Now, suppose the price levels in the two countries remain the same but
somehow exchange rate moves to $1 =46 rupees.Dr. Geetanjali Diwani

5. Explanation contd.
This means that one US$ can
purchase commodities worth more
than 45 rupees.
It will pay people to convert dollars
into rupees at the rate ($1 = Rs.
46), purchase the given collection
of commodities in India for 45
rupees and sell them in U.S.A. for
one dollar again, making a profit
of 1 rupee per dollar worth of
transactions.
This will create a large demand for
rupees in the USA while supply
thereof will be less because very
few people would export
commodities from USA to India.
The value of the rupee in terms of
the dollar will move up until it will
reach $1 = 45 rupees.
At that point, imports from India
will not give abnormal profits.
$ 1 = 45 rupees is called the
purchasing power parity between
the two countries.
Dr. Geetanjali Diwani

6. Explanation contd.
Thus, while the value of the unit of one currency
in terms of another currency is determined at
any particular time by the market conditions of
demand and supply, in the long run the exchange
rate is determined by the relative values of the
two currencies as indicated by their respective
purchasing powers over goods and services.
In other words, the rate of exchange tends to rest
at the point which expresses equality between the
respective purchasing powers of the two
currencies. This point is called the purchasing
power parity.
Dr. Geetanjali Diwani

7. Explanation contd.
Dr. Geetanjali Diwani
Thus, under a system of
autonomous paper
standards the external value
of a currency is said to
depend ultimately on the
domestic purchasing power
of that currency relative to
that of another currency.
In other words, exchange
rates, under such a system,
tend to be determined by
the relative purchasing
power parities of different
currencies in different
countries.
In the above example,
if prices in India get
doubled, the value of
the rupee will be
exactly halved.
The new parity will be
$1 = 90 rupees.
This is because now 90
rupees will buy the
same collection of
commodities in India
which 45 rupees did
before.
We suppose that prices
in USA remain as
before.
But if prices in both
countries get doubled,
there will be no change
in the parity.

8. The theory has
two versions –
The absolute
purchasing
power parity
theory
The relative
purchasing
power parity
theory
Dr. Geetanjali Diwani

9. Absolute Purchasing Power Parity Theory
According to the absolute version of purchasing power parity theory, the equilibrium exchange rate is determined in terms of the ratio
of the absolute price levels in any two countries. The exchange rate under this version of the PPP theory is given as,
ER = PA/ PB
Where, ER is exchange rate
PA is price level in country A
PB is price level in country B
For example, if a basket of goods can be bought in India for ₹ 100 and in the US for $2. In this case, the exchange rate between the
Indian rupee and the US Dollar will be determined as follows:
ER (₹ / $) = PA/ PB = 100/2 = ₹50
Dr. Geetanjali Diwani

10. Absolute Purchasing Power Parity Theory
Assumptions
There are no transportation
costs.
There are no tariffs on imports
and subsidies on exports.
There is free trade between
nations.
Dr. Geetanjali Diwani

11. Criticisms
It ignores the effect of
transportation costs which
affect the final price paid
by traders.
Many countries impose
tariffs on imports and
subsidize exports. These
factors affect the price and
hence, the real purchasing
power of the currency.
It takes account only
traded goods and services
and ignores the price levels
of non-traded goods which
are the part and parcel of
the general price level
The theory ignores capital
account transactions which
do matter in exchange rate
determination.
Dr. Geetanjali Diwani
Absolute Purchasing Power Parity Theory

12. Relative Purchasing Power Parity Theory
The relative purchasing power parity theory is a modified version of its absolute version.
While the absolute version assumes the price level to remain constant, in reality, price levels do not remain constant.
A change in price level is bound to change the exchange rate.
The relative purchasing power parity theory gives a measure of the change in the exchange rate under the conditions of changes in
relative prices.
Relative purchasing power parity theory states that the relative change in the exchange rate over time is proportional to thechange
in the relative price level over a period of time.
The formula for relative purchasing power parity theory is given as ERN = (PAN / PA0 )/ PBN / PB0= ER0 .
ERN and ER0 are the exchange rates in year N and base year 0, respectively
PAN and PA0 are the price levels in country A in year N and base year 0, respectively
PBN and PB0 are the price levels in country in year N and base year 0, respectively
Dr. Geetanjali Diwani

13. The basic purpose of the relative PPP theory is to determine the equilibrium exchange rate under
conditions of changing price levels.
Also, the relative PPP theory can be used to measure the change in the exchange rate owing to a
change in the price levels.
Suppose, there are two countries A and B and their respective price levels in the base years are given
as PA0 = 100 and PB0 = 100. In this case, the exchange rate between the currencies of the two
countries can be expressed as
ER = PA0 / PB0 = 100/100 = 1
Now let the price levels in the two countries in year N change to PAN = 150 and PBN = 200,
respectively. In this case, the relative exchange rate in year N between the two countries can be
measured as
Dr. Geetanjali Diwani

14. RERN = (PAN / PA0 ) / PBN / PB0 = (150/100) / (200/100) =1.5/ 2 = 0.75
This shows that the currency in country B has depreciated by 0.25 or by 25%.
This calculation shows that if the price index in country A increases in year N
from 100 to 150 i.e., 50%, and the price level in country B increases from 100 to
200, the currency in country B depreciates by 25% in year N due to a higher
rise in its price level.
Dr. Geetanjali Diwani

15. Dr. Geetanjali Diwani
Criticism
It is based on the general price index of a country. This index included prices of both traded and non-traded goods and services whereas the
exchange termination pertains only to internationally traded goods and services. Therefore, the relative purchasing power parity theory yields a
misleading exchange rate.
The base year and weightage of goods and services used in the construction of the price index varies from country to country depending on the
nature and structure of production. Therefore, the price index number does not reflect the relative price level in the different countries. The variation
in the exchange rate under this condition based on the relative prize structure does not reflect the actual purchasing power.
Apart from the non-traded goods and services, certain kinds of services such as banking, insurance, consultancy services etc. are considered part of
foreign transactions but not included in the price index number. Therefore, changes in relative prices to not reflect changes in purchasing power of a
currency.
A large amount of capital transfer takes place between Nations which affect the demand for foreign exchange. The change in the demand for
foreign exchange does not affect the exchange rate. But this kind of change in exchange rate is not accounted for in the relative purchasing power
parity theory.
The imposition of tariffs and the provision of subsidies causes a change in the actual purchasing power of a currency. But such factors are not
accounted for by the relative purchasing power parity theory.
A change in the exchange rate depends, by and large, on the elasticities of reciprocal demand for foreign exchange but the theory only recognises a
change in the exchange rate owing to changes in relative prices.
The relative purchasing power parity theory postulates that relative commodity prices are the sole determinants of international transactions and
that a change in the relative prices is the sole determinant of exchange rate. But in reality, changes in the exchange rate are also because of
disequilibrium in balance of payment caused by capital transfers, service payment and changes in real income.