Concept of PPP Theory And Exchange Pegging
A Swedish Economist, Gustav Cassel, developed the concept of equilibrium rate of exchange, popularly known as the Purchasing Power Parity Theory, (PPP) after the First World War. This theory asserts that “the relative value of different currencies correspond to the relation between the real purchasing power of each currency in its own country.” The purchasing power parity theory can be stated in the form of the following two statements :
1. Under inconvertible paper standard, the absolute rate of exchange between any two currencies is determined on the basis of their purchasing power in their respective countries.
2. The relative change in exchange rate between any two currencies is proportional to the change in the relative prices.
The absolute rate of exchange is determined in terms of absolute prices. For example, suppose a basket of goods and services can be bought in India for 100 and in the US for $2, both currencies being inconvertible paper currencies. Then the exchange rate between the two currencies will be determined as given below:
$2 = 100
$150 (100+2)
The determination of the absolute rate of exchange is based on the assumption that there is no cost of transportation, no tariffs, and no subsidies. It is therefore argued that since this assumption is unrealistic, the entire theory is unrealistic. However, the absolute exchange rate can be worked out without this assumption by adjusting the commodity price for transportation cost, tariffs and subsidies.
Exchange Pegging
When the value of domestic currency is tied to the value of another currency, it is called ‘pegging.’ Under the fixed exchange rate system, a currency is pegged to a reserve currency or to a basket of ‘key’ currencies. Besides, currencies are pegged also to the Special Drawing Rights (SDRs), an instrument created by the International Monetary Fund (IMF). The currencies of about one-third of the developing nations are pegged to a single currency, that is, either to the US dollar or to French franc. The value of a pegged currency is allowed to vary within a certain lower and upper limit.
Pegging of a currency to a basket of currencies is called composite currency pegging. This system is adopted to avoid frequent adjustment problem caused by the variation in the reserve currency. Under this system, many countries have pegged their currency to more than one currency, mainly to the currencies of their major trading partners. This ensures a greater degree of stability in the fixed exchange rate. In this system, the rate of exchange is fixed on the basis of a weighted average value of the selected currencies. The currency basket is determined on the basis of the regional distribution of trade partners and the volume of trade and foreign investment. The European monetary system or the Euro currency system is the best example of this system. India has pegged her currency to the US dollars, SDRS and the pound sterling.
