Purchasing Power Parity Theory

Mint Parity Theory or PPP Theory 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 t respective countries.

2. The relative change in exchange rate between any two currencies is proportional to the change in the relative prices.

Drawbacks of the PPP Theory

The purchasing parity theory has been criticized on the following grounds:

(i) The wholesale price index number (WPI) used in PPP theory does not give an accurate and relevant measure of purchasing power of a currency in the context of foreign trade. For determining the purchasing power of a currency, prices of only internationally traded goods are relevant, not the domestic price of all goods and services. Therefore, it does not give a realistic exchange rate.

(ii) Apart from goods, many service items, for instance; banking, insurance etc. enter the international transactions. Besides, a large amount of capital transfer take place between the nations. Such transactions do affect purchasing power of a currency but WPI does not take these transactions into account.

(iii) Tariffs, subsidy and embargo cause significance effect on the purchasing power of a currency. But such items are not taken care of in computing exchange rate as per this theory. (MV)

The change in the exchange rate depends, by and large, on elasticities of the demand for imports and exports. But, PPP theory does not take this factor into consideration.

Finally, the PPP theory assumes that relative price is the sole determinant of foreign exchange transactions. This is not true. Changes in the exchange rate are also caused by capital transfers, service payments and changes in the real income of the consumers.

In spite of these shortcomings, however, PPP theory is widely used as the first approximation of an equilibrium rate of exchange for periods of serious and frequent price changes. For a more accurate measure of the exchange rate, other factors like capital transfers, changes in production technique and in real incomes need to be accounted for.