Definition: The Purchasing Power Parity or PPP theory posit that the relative value of different currencies equates the real purchasing power of each currency in its own country.
In other words, under inconvertible paper currency system, the exchange rate between two countries can be determined on the basis of their purchasing power in their own respective countries. For example, if an item of good can be purchased for Rs 200 in India and $4 in the USA and if both countries work on inconvertible paper currency, then the exchange rate between both the countries will be determined as $4 = Rs 200, 1 $ = Rs 50.
The purchasing power parity does not apply to absolute levels of prices, which depends on a number of factors operating under different conditions. In fact, it is impossible to measure the absolute prices. Also, the purchase power parity can nevertheless be used to explain the change in the international prices as well as for determining the changes in the exchange rate. For example, Let Pa and Pb represent the price levels in two countries X and Y in the base year (0), and Ro be the exchange rate between both the countries. The rate of exchange R1 between the two countries at some time in the future can be determined as:
The Purchasing Power Parity theory is criticized on the following grounds:
- It only helps in determining the change in exchange rate, not the absolute exchange rate. This means the PPP theory does not apply to the absolute values.
- The purchasing power parity depends on the wholesale price index number which does not give an accurate measure of a change in the purchasing power.
- While the purchasing power of the currency in terms of only internationally traded goods is relevant only for its external value, the wholesale price index includes the price of all the commodities.
- Apart from goods, several services such as banking, insurance, consultancy enter the foreign transactions and large capital transfers take place between the countries which do not enter in the wholesale price index number.
- Although the PPP theory recognizes that the change in the exchange rate is only due to the change in the relative prices, however, the change in the exchange rate, by and large, depends on the elasticities of reciprocal demand.
- The PPP theory assumes that the commodity prices are the major determinants of international transactions and the change in the relative prices are the sole determinants of the exchange rate. But practically, the changes in the exchange rate does take place due to the disequilibrium caused due to capital transfers, change in real income and service payments.
Despite these limitations, the purchasing power parity theory is used as the first approximation to an equilibrium exchange rate at the time of high and frequent price changes.