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Purchasing Power Parity Theory of Exchange Rate

By: EconomyWatch Date: 14 October 2010

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Purchasing Power Parity Theory of Exchange Rate is a theory, which establishes the fact that the exchange rates between currencies are in equilibrium in the event of equality in the purchasing power of each of the countries. This precisely means that the ratio of the price level of a fixed amount of goods and services of the two countries and the exchange rate between those two countries must be equivalent. PPP is based on the ‘Law of One Price’. If the inflation rate within a country’s economy increases then the value of the currency needs to depreciate to revive the PPP. In the absence of transportation and other similar expenses, the competitive market will equalize the price of an identical object in two countries when the prices are expressed by the same currency. However, one has to be careful with the Law of one Price. The application of the Law of One Price is contingent upon certain conditions. They are:

A competitive market must be present in both the countries for the goods and services
The law is only applicable to the goods that can be traded between the countries.
Transport expenses and other transaction expenses must be checked since they are considered hindrances in trading.

Types of PPP

There are two types of PPP. They are:
Absolute Purchasing Power Parity that is based on the maintenance of equal prices in two concerned countries.
Relative PPP describes the inflation rate. This describes the appreciation rate of a currency, which is decided by calculating the difference between the exchange rates of two countries.

Calculation of PPP

Purchasing Power Parity is calculated by comparing the price of an identical good in both the countries. The “Hamburger Index” in The Economist magazine presents the index in a jovial manner every year. But the calculation is not free from problem because consumers in every country consume different types of products. Another index is the iPOD Index. The iPOD is considered to be one of the standard consumer products these days. Hence PPP can be calculated by comparing its price.

The PPP is unable to display the right picture of the standard of living. There are certain difficulties since the PPP number vary with specific amount of goods. PPP is very often utilized to measure the poverty rates in countries.