2. Purchasing Power Parity Theory
• Currencies are used for purchasing goods and services
• Value of a currency (money) depends upon the
quantity of goods and services that can be purchased
by the currency
• Thus, value of money is its purchasing power
• Exchange rate can also be mentioned on the basis of
this purchasing power
• Exchange rate is the expression of one currency in
terms of another currency
Eg INR 60 = $ 1
3. Suppose by using Rs 60, we can purchase one kilogram of
orange, then the purchasing power of Rupees can be
expressed as –
– Rs 60 = 1 kg orange
• Similarly for purchasing one kg orange, we have to pay one
dollar, then the purchasing power of dollar can be expressed
as –
– $1 = 1 kg orange
Now it is possible to state the exchange rates in terms of the
value of orange
– Rs 60 = 1kg orange = $ 1
Now it is possible to express the exchange rate in terms of
their purchasing power as
– INR 60 = $1
This expression is on the basis of the parity of purchasing
power of the two currencies
4. Purchasing power of currency changes due to
inflation or deflation
When there is inflation, price level increases,
quantity of goods that can be purchased by one unit
of currency declines, thus, the purchasing power
also decline and vice versa
Thus, inflation / deflation affect the exchange rates
Purchasing power parity theory explains the
relationship between exchange rate and inflation
This theory is based one “Law of one price”
5. Law of one price states that any commodity cannot
command two different prices in two different
markets. If so profits can be taken by trading
between these two markets. Ultimately the
difference will set off the price differential and prices
of the two markets become equal.
PPP theory was proposed by David Ricardo, 19th
century, popularized by Gustav Cassel –in 1920s
According to this theory, exchange rate of a
commodity is determined on the basis of the
purchasing power of the currency
6. This theory considers foreign exchange as a commodity
Under gold standard, the exchange rate can be stated in
terms of the price of “Mint parity of gold”
But in flexible or floating exchange rate system – in the era
of paper currencies, currencies are not backed up by gold
or gold exchange standard, currencies are not based on
their intrinsic worth in terms of gold
Thus, to determine the exchange rate, purchasing power
of the two currencies can be considered
In other words, the exchange rate of two currencies can
be determined on the basis of products of commodities
that can be purchased by the currencies
According to this theory exchange rates are determined by
what each unit of a currency can buy in terms of real
goods and services in its own country
7. The rate of exchange is the amount of
currency which would buy the equivalent
basket of goods and services in both the
countries
As mentioned, to purchase one Kg of orange,
in India, we have to pay Rs. 50 and at the
same time to purchase the same quantity of
orange in US, one has to pay $1. in that case
Exchange rate (E) = Price of orange in India /
Price of orange in US = 50/1 or 50:1
8. Assumptions of law of one price and PPP theory
1. There exist perfect market conditions
2. Absence of transportation costs from one market to
another (country to another)
3. Free trade across the international market
4. No barriers or controls over international trade like
tariffs, taxes, incentives, promotions etc
5. No country is strong enough to influence the exchange
rate
The above mentioned practices are termed as frictions in
trade and are distortions in free markets
If the above assumptions hold good, law of one price will
prevail
9. There are two versions to the PPP theory
1. The absolute PPP (Positive version) and
2. The relative PPP (Comparative version)
Absolute PPP Theory
In the olden days (1700 -1970) gold formed the basis for
determination of the exchange rate because it commanded good
demand all over the world
Today, gold is like any other commodity
Thus, in the olden days PPP was based on gold prices
According to the Jamaica Agreement in 1976 gold was
demonetized
The PPP and the exchange rates are not determined or governed
by a single commodity like gold
Now, it comprises of a basket of commodities in which gold is
only a commodity
10. Thus, for the purpose of determining the
exchange rate a basket of commodities which
have common utility among the natives will be
considered.
The value of commodities in different places
may differ according to customs, traditions,
culture, believes etc.
For determining the inflation rates, every
country forms a common basket of goods in
proportion to their utility to the people
Based on variations in prices inflationary
tendencies are determined.
11. Inflation influences exchange rates
• Two countries India and China. Inflation rate in India
is 20% and that of China is 0%; then the INR will
depreciate when compared to Chinese Yuan.
• In other words, Chinese Yuan will appreciate when
compared to INR
• Formerly the currencies were in equilibrium position
and were traded INR 5 = 2 Yuan on account of
inflation the position can be INR 6 = 2 Yuan
• Now Chinese get more INR for their Yuan and they
can purchase more goods from India by giving their
Yuan
• This will increase Chinese import from India and or
Indian export to China.
12. • Thereby increasing demand for Indian Rupees from
Chinese who pay in term of their Yuan. Demand for
INR leads to increase exchange rate of INR and
increased supply of Yuan tends to reduce the price
of Yuan.
• Thus, ultimately through the interaction of market
forces, the exchange rate reaches again in
equilibrium position
13. Demerits
1. Assumes composition of common basket of goods. Due
to factors like culture, tradition, values believes etc.
common goods may not be the same
2. Assumes identical utility – but utility is different
3. Quality of goods may be different in different countries
4. Styling and packing difference
5. Trade barriers
6. Transportation, insurance cost etc
7. Non-tradable goods (service, human resource)
8. Time lag : consequence of inflation may occur in
different time
9. Other factors affecting demand and supply of currencies
- interest, investment portfolio returns etc
14. Relative Purchasing Power Parity Theory
Absolute PPP theory has certain limitations or distortions
– thus, may not hold good
Thus, Relative PPP theory
This theory considers the impact of market imperfections
like transportation cost, tariffs, quotas, incentives etc.
Imperfections result in different prices for the same
commodities in different countries, even if measured in a
common currency
However, this theory argues that “the rate of exchange in
the prices of products will be some what similar when
measured in common currency, as long as the
transportation costs and trade barriers are unchanged
In other words, “the change in the exchange rate over a
period of time should be proportional to the relative
change in the price levels in two countries over the same
period”
15. Example, Suppose:-
t = 0 (base period or year)
Pₒd = Price of the commodity in domestic country during the
base period
Pₒf = Price of the commodity in foreign country during the base
period
Thus, exchange (spot) rate = Sₒ = Pₒd/ Pₒf
Suppose if the prices changes due to inflation, after one year
the situation will be
t = 1 (after one year)
P₁d = Price of the commodity in domestic country after one
year
P₁f = Price of the commodity in foreign country after one year
Thus, exchange (spot) rate = S₁ = P₁d/ P₁f
16. P₁d = Pₒd + inflation in domestic country
P₁f = Pₒf + inflation in foreign country
If, Inflation in domestic country = Id
inflation in foreign country = If
Thus, S₁ = Pₒd ( 1 + Id) / Pₒf (1 +If) or
17. Suppose the price of 1 kg orange in India is INR
50 and that in USA is $1. The inflation rate in
India is 20% and that of USA is 10%.
Determine the new exchange rate
When t=o, Sₒ = Sₒ = Pₒd / Pₒf = 50/1
= INR50: $1
t=1, inflation in India (Id), 20 % 0r 0.2 and
inflation in USA (If) is 10% or 0.1
Present exchange rate will be
50 x (1+0.2/1+0.1) = INR 54.45 : $ 1
18. Nominal exchange rates and Real
exchange rates
Nominal rate is the current rate or prevailing rate
without making any adjustment for inflation
Real rate is the nominal rate adjusted to the
inflation or price level changes
Since due to inflation, the purchasing power of
currency declines, thus, in such situations, the
currency is said to be depreciating its value
