Although the origins of the theory date back to the 16th century, Gustav Cassel proposed the modern form of the theory of purchasing power parity in 1918. It is an economic theory used initially just for determination of exchange rates but recently as a measure of comparison among living standards of different nations as well. The concept of ‘Purchasing Power Parity’ is based on the law of one price. It means that the prices in two different countries should be identical when the currencies are converted into a common currency. In other words, the phrase purchasing power parity means equality in terms of the ability of currency to buy goods and services in domestic and foreign economies.
What is the rationale behind the PPT theory?
A country experiencing high inflation faces decreased demand for its own in the foreign markets i.e. reduction in exports. Moreover, the demand of the domestic consumers increases for foreign goods i.e. rise in imports. The negative balance of trade causes devaluation of local currency in the international market. The theory of PPP states that this weakening of the currency will eventually balance out the difference in the prices. The foreign goods will no longer seem attractive to local customers as the price differential will be countered by exchange rate differential. This will eliminate the arbitrage opportunity where individuals can buy in one country at cheaper rates and sell in the other country at higher rates.
Does the PPP hold? Discuss with examples.
Absolute PPP assumes that the exchange rates are only affected by inflation rates. However, practically this does not hold true. Exchange rate determination is influenced by several factors like public debt level, interest rate variations, expansionary or contractionary government policies, political and economic conditions of the country etc. Moreover, PPP ignores transportation costs, import controls and the value of non-tradable goods and services. For example according to PPP a service like haircutting should cost the same in all the countries of the world. However, several researches have shown that in developing economies, such services are almost 10 times cheaper than in developed economies. Moreover, if a country has imposed 75% tax on imported tennis racquets, the rationale of PPP will not hold anymore as the importer is paying cost plus tax for the good. Research has confirmed that PPP holds only in the long run where prices and exchange rates adjust through market forces. However in the short term, prices and exchange rates don’t adjust so quickly.
