What Is Purchasing Power Parity Theory of Exchange Rate

Purchasing Power Parity Theory of Exchange Rate.The purchasing power parity theory was developed by Gustav Cassel in 1920 to determine the exchange rate between countries on inconvertible paper currencies. The theory states that equilibrium exchange rate between the inconvertible paper currencies is determined by the equality of their purchasing power.

Purchasing Power Parity Theory of Exchange Rate;5 Examples

In other words, their relative price levels determine the rate of exchange between the countries. The theory can be explained with the help of an example:

Suppose Pakistan and England are on inconvertible paper standard and by spending Rs. 140 the same bundle of goods can be purchased in Pakistan as can be bought by spending pound 1 in England. Thus according to the purchasing power parity theory, the rate of exchange will be Rs. 140 = pound 1.

According to the theory, the exchange rate between two countries is determined at a point, which expresses the equality between the respective purchasing powers of the two currencies. This is the purchasing power parity, which is a moving par and not a fixed par as under the gold standard. Thus with every change in the price level, the exchange rate also changes. To calculate the new equilibrium exchange rate, the following formula is used:

R = Domestic Price of a Foreign Currency x Domestic Price Index/Foreign Price Index

\< cording to Cassel:

“The purchasing power parity is determined by the quotients of the purchasing powers of the different currencies

To explain it in terms of our above example before the change in the price level, the exchange rate was Rs. 140 = Pound 1. Suppose the domestic (Pakistani) price index rises to 300 and the foreign (England) pi u c index rises to 200. Thus the new equilibrium exchange rate will be:


Pound 1 x 300


= Pound 1.5


Rs. 140 = Pound 1.5

Chis will be the purchasing power parity between the two countries.

CRITICISMS Purchasing Power Parity Theory of Exchange Rate

The main criticisms against the theory are as follows:

  1. Vague Idea of Price:

Purchasing power parity theory attempts to determine exchange nites on the basis of the purchasing power of the respective currencies, which is reciprocal of the price level of the country. Therefore, the determination of rates of exchange on the basis of the vague idea of price levels is not appropriate since it includes a large quantity of those items, which have nothing to do with rate of exchange.

  1. No Proportional Change in Price:

Price-level may be taken safely as the basis for determining rate of exchange according to the purchasing power parity, if we assume that the price of internally trades as well as internationally trades goods change in Ilie same direction and proportion. They may do so but it is not necessarily I he case. Therefore the assumption to this account is not safe.

  1. No Practical Application:

The notion of price level itself is vague. Theoretically alone, we can conceive of such price level and practically we can only measure change in it through the device of index number. That is why, it is said that this theory only explains changes in exchange rates but does not actually determine them.

  1. Free Trade:

This theory presumes that there must be free trade. Only then the fluctuation in the rates of exchange can be adjusted to the price levels by increasing or decreasing the volume of exports and imports. But in actual practice this is not the case. Free trade has almost disappeared from the scene after First World War.

  1. Supply and Demand of Foreign Exchange:

Fhe purchasing power parity theory assumes that the supply and demand of currencies in the foreign exchange markets are simply due to imports and exports of goods. But this is not actually the case.

  1. Ignoring Other Factors:

The exchange rate of currency might change due to speculation, victory or defeat in war and such other events, which have absolutely no connection with the price levels.

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