Critically examine the Purchasing Power Parity (PPP) Theory of Exchange Rate Determination

QUESTION-

Critically examine the Purchasing Power Parity (PPP) Theory? Do you agree that PPP is not very realistic?   On what grounds Keynes criticized the 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.

Let us take another example. Suppose in the USA one $ purchases a given collection of commodities. In India, same collection of goods cost 65 rupees. Then rate of exchange will tend to be $ 1 = 65 rupees. Now, suppose the price levels in the two countries remain the same but somehow exchange rate moves to $1=66 rupees.

Thus, while the value of the unit of one currency in terms of another currency is determined at any particular time by the market conditions of demand and supply, in the long run the exchange rate is determined by the relative values of the two currencies as indicated by their respective purchasing powers over goods and services.

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.

 In this equation 'P' denotes prices related to the respective bundle of goods with same weights assigned in both the countries. Thus, the above equation explains that the equilibrium exchange rate(R) is determined by the ratio of the internal purchasing power of foreign currency and domestic currency in their own countries. This concept is derived from a basic idea known as the law of one price (LOOP), which states that the real price of a good must be the same across all countries.

R = P / P* where R is the spot exchange rate. P is the price index for domestic country and P* is the price index for foreign country.

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.
 The relative version was put forward by Cassel in order to find the strength of the changes in the equilibrium exchange rate. Any departure from the equilibrium will lead to the disequilibrium. It can take place due to changes in the internal purchasing power of a particular currency. The changes in the purchasing power are measured with the help of domestic price indices if the respective nation. We need to assume any past rate of exchange as a base exchange rate in order to know the percentage change in the exchange rate. If we compare the price indices in the past i.e. base period with that of the present period, the new equilibrium exchange rate could be found out.

It can be simplified with the following equation. Thus, according to the equation when the price level in concerned nation changes, automatically the internal purchasing power of the currency of that nation goes on changing. This change leads to the change in the equilibrium exchange rate. Thus, under this theory Gustav Cassel has tried to link the purchasing power of two currencies in determining the equilibrium exchange rate.

Criticism of Purchasing Power Parity (PPP) Theory

The Purchasing Power Parity Theory ignores these influences altogether. Further, the theory, as propounded by Cassel, says that changes in price level bring about changes in exchange rates but changes in ex­change rates do not cause any change in prices. This latter part is not true, for exchange movements do exercise some influence on internal prices.

Limitations of the Price Index: As seen above in the relative version the PPP theory uses the price index in order to measure the changes in the equilibrium rate of exchange. However, price indices suffer from various limitations and thus theory too.

Neglect of the demand / supply approach: The theory fails to explain the demand for as well as the supply of foreign exchange. The PPP theory proves to be unsatisfactory due to this negligence. Because in actual practice the exchange rate is determined according to the market forces such as the demand for and supply of foreign currency.

Unrealistic Approach: Since the PPP theory uses price indices which itself proves to be unrealistic. The reason for this is that the quality of goods and services included in the indices differs from nation to nation. Thus, any comparison without due significance for the quality proves to be unrealistic.

Unrealistic Assumptions: It is yet another valid criticism that the PPP theory is based on the unrealistic assumptions such as absence of transport cost. Also, it wrongly assumes that there is an absence of any barriers to the international trade.

Neglects Impact of International Capital Flow: The PPP theory neglects the impact of the international capital movements on the foreign exchange market. International capital flows may cause fluctuations in the existing exchange rate.

Rare Occurrence: According to critics, the PPP theory is in contrast to the Practical approach. Because, the rate of exchange between any two currencies based on the domestic price ratios is a very rare occurrence.

Keynes’ Critique:

According to Keynes, there are two basic defects in the purchasing power parity theory, namely:

(i) It does not take into consideration the elasticities of reciprocal demand, and

(ii) It ignores the influences of capital movements.

Thus, the PPP theory is criticized on the above grounds.

Despite these criticisms the theory focuses on the following major points.

It tries to establish relationship between domestic price level and the exchange rates.

The theory explains the nature of trade as well as considers the BOP (Balance of Payments) of a nation.

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