Discuss the Law of One Price as the basis of PPP. What are the two main types of the PPP theory?

The purchasing power parity theory was propounded by Professor Gustav Cassel of Sweden. According to this theory, rate of exchange between two countries depends upon the relative purchas­ing power of their respective currencies. Such will be the rate which equates the two purchasing powers. For example, if a certain assortment of goods can be had for £1 in Britain and a similar assortment with Rs. 80 in India, then it is clear that the purchasing power of £ 1 in Britain is equal to the purchasing power of Rs. 80 in India. Thus, the rate of exchange, according to purchasing power parity theory, will be £1 = Rs. 80.

The Law of One Price (LOOP)

The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency. For example, a particular smart phone sells for  Rs.25750 in india and cost 300 US Dollars [USD] in new York when the exchange rate between Rs. and the US is 65 INR/USD. If the price of the Smart Phone in India was only 13,000 CAD, consumers in new York would prefer buying the Smart phone set in India. If this process (called "arbitrage") is carried out at a large scale, the US consumers buying Indian goods will bid up the value of the Indian Rupees, thus making Indian goods more costly to them. This process continues until the goods have again the same price.

There are three caveats with this law of one price.

(1) As mentioned above, transportation costs, barriers to trade, and other transaction costs, can be significant.

 (2) There must be competitive markets for the goods and services in both countries.

(3) The law of one price only applies to tradeable goods; immobile goods such as houses, and many services that are local, are of course not traded between countries.

Types

The two version of Purchasing Power Parity are:

(i) Absolute PPP and

(ii) Relative PPP.

(i) Absolute Purchasing Power Parity:    The absolute version of this theory maintains the that the absolute purchasing power of respective currencies does play a vital role in determining the equilibrium exchange rate.

The following conditions must be met for this relationship to be true:
1. The goods of each country must be freely tradable on the international market.
2. The price index for each of the two countries must be comprised of the same basket of goods.
3. All of the prices need to be indexed to the same year.

Relative Purchasing Power Parity

 Relative PPP describes the inflation rate, or the appreciation rate of a currency by calculating the difference between two countries’ exchange rates. Relative PPP is the more dynamic version of absolute PPP theory. Relative purchasing power parity relates the change in two countries' expected inflation rates to the change in their exchange rates. Inflation reduces the real purchasing power of a nation's currency.

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