What is Purchasing Power Parity?
Purchasing power parity (PPP) is an economic theory and a technique used to determine the relative value of currencies, estimating the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to (or on par with) each currency’s purchasing power.
PPP theory specify a precise relationship between relative inflation rates of two countries and their exchange rates. PPP theory suggests that the equilibrium exchange rate will adjust the same magnitude as the differential in inflation rates between two countries.
Table of Contents
What is Purchasing Power Parity Theory?
The purchasing power parity theory (PPP) of exchange rate determination states that the exchange rate between any two currencies equals the ratio of their price levels. The PPP theory focuses on the inflation-exchange rate relationships.
This theory is said to have been originally formulated by Wheatley in 1802 and later by Blake in 1810. However, according to Krugman and Obstfeld, ‘The basic idea of PPP was put forth in the writings of 19th-century British economists, among them David Ricardo (the originator of the theory of comparative advantage).’
Whoever might be the originator of the basic idea of the PPP theory, it was Gustav Cassel, a Swedish economist, who reformulated the PPP theory and developed the concept of an equilibrium rate of exchange in 1920.
‘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 the rate of exchange.
The PPP theory has two versions:
- The absolute purchasing power parity theory
- The relative purchasing power parity theory
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.
Absolute PPP Theory Formula
The exchange rate under this version of the PPP theory is given as,
ER = PA / PB
where ER = exchange rate, PA = price level in country A, and PB = price level in country B.
For example, suppose a basket of goods can be bought in India for ₹100 and in the US for $2. In that case, the exchange rate between the Indian rupee (INR) and the US$ will be determined as follows:
Assumption of PPP Theory
The absolute version of the PPP theory is based on the following assumptions:
- There are no transportation costs.
- There are no tariffs on imports and subsidies on exports.
- There is free trade between nations.
Criticism of Absolute PPP theory
The absolute version of the PPP theory has certain serious shortcomings which make its validity questionable.
- 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 into account only traded goods and services and ignores the price levels of non-traded goods which are part and parcel of the general price level. Also, the PPP theory ignores capital account transactions which do matter in exchange rate determination
Relative Purchasing Power Parity Theory
The relative purchasing power parity theory is a modified version of its absolute version. While the absolute version assumes price level to remain constant, in reality, price levels do not remain constant. And a change in price levels is bound to change the exchange rate.
The relative PPP theory gives a measure of the change in the exchange rate under the conditions of changes in relative prices.
The relative PPP theory states that the relative change in the exchange rate over time is proportional to the change in the relative price level over a period of time.
Relative PPP Theory Formula
The formula for relative PPP theory is given as,
ERN = (PAN / PA0 ) / (PBN / PB0 ) = ER0
where:
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 B year N and base year 0, respectively
In fact, 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.
For example, suppose there are two counties A and B and their respective price levels in the base year 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,
ERN = 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 that case, the relative exchange rate (RER) in year N between the two countries can be measured as follows:
PERN = (PAN / PA0 ) / (PBN / PB0 ) = (150 / 100) / (200 / 100)
This measure of relative PPP shows that the currency in country B has depreciated by 0.25 or by 25 per cent. The above calculation shows that if the price index in country A increases in year N from 100 to 150, i.e., 50 per cent, and the price level in country B increases from 100 to 200, the currency in country B depreciates by 25 per cent in year N due to a higher rise in its price level.
Criticism of Relative PPP theory
Most of the deficiencies of the absolute PPP theory apply also to the relative PPP theory of exchange rate. The relative PPP theory has been criticized also on the following grounds:
- 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 determination pertains only to internationally traded goods and services. Therefore, the relative PPP theory yields a misleading exchange rate.
- The base year and weightage of goods 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 levels in the different countries. The variation in the exchange rate under this condition based on the relative price structure does not reflect the actual purchasing power. - Apart from non-traded goods and services, certain kinds of services, such as banking, insurance, consultancy services, etc., are considered part of foreign transactions but they are not included in the price index number. Therefore, changes in relative prices do not reflect changes in the purchasing power of a currency.
- A large amount of capital transfers take place between nations, which affect the demand for foreign exchange. The change in the demand for foreign exchange does affect the exchange rate. But this kind of a change in exchange rate is not accounted for in the relative PPP theory.
- As Haberler has pointed out, the imposition of an embargo or 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 theory.
- A change in the exchange rate depends, by and large, on the elasticities of reciprocal demand for foreign exchange but the PPP theory only recognizes a change in the exchange rate owing to changes in relative prices.
- The relative PPP theory postulates that relative commodity prices are the sole determinants of international transactions and that a change in relative prices is the sole determinant of the exchange rate.
But in reality, changes in the exchange rate are also because of disequilibrium in BOP caused by capital transfers, service payments, and changes in real income.
