2c.purchasing Power Parity Theory

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PPP theory holds that the exchange rate between two currencies isdetermined by the relative purchasing power reflected in the pricelevels expressed in domestic currencies in two countries concerned.

Changes in the exchange rates are explained by relative changes inthe purchasing power of the currencies caused by inflation in therespective countries concerned.

The concept of PPP is originally traced to the British economistDavid Ricardo, but the credit for stating the theory in an orderlymanner is given to Swedish economist Gustav Cassel whoproposed it in 1918 as the basis for new set of exchange rates forresumption of normal trade relations at the end of the First WorldWar.

PPP theory is stated in two versions

the Absolute Version and theRelative Version.

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This is based on the law of one price. This law states that underconditions of free market with the absence of transportation cost,

tariffs and other frictions to free trade, the price for identical goodsshould be the same at any market when measured in terms ofcommon currency.

Example; if a particular quality of coffee seeds costs Rs. 100 per Kgin India and the same commodity cost $ 2 in USA. The exchangerate between $ and Rs in the market will be Rs. 50. This means that

when the $ price of coffee is converted into Rs. it will be the sameRs.100 prevailing in the domestic market.

If the exchange rate in the market is anything other than Rs. 50, itwill lead to arbitrage possibilities. The arbi trage operat ions wi l lul t imately lead the exchange rate to the equi l ibr ium level.

Suppose the market rate for $ is Rs. 45. In the absence oftransaction costs, traders in India will find that the coffee seeds inUSA is priced low in terms of $ as compared to its rupee price. Theywill find it advantageous to buy coffee seeds in USA and sell in thedomestic market.

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Suppose a trader imports 1000 Kgs of coffee seeds. He will pay Rs.90,000 to acquire $ 2000 from the market. He can sell 1000 Kgs ofcoffee seeds in the domestic market at Rs. 100 per Kg and earn a

profit of Rs. 10,000. Similar operations will be done by other traders in India to take

advantage of the situation. The combined effect of the operations ofall the traders is that the demand for $ increases in the foreignexchange market, pushing its price in terms of rupees.

The $ will continue to strengthen until the arbitrage profit is totallyeliminated. That is the level where the price of coffee is same whenmeasured in terms of either rupee or $.

In the reverse situation, if the exchange rate per $ is Rs. 54, tradersin India will find it advantageous to sell coffee seeds in USA to get ahigher price realisation.

The operations by all traders will lead to increase in the supply of $in the market exerting downward pressure on its price in terms ofrupee. The exchange rate will move to a level where arbitrage is nomore possible.

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Instead of a single commodity, we can imagine a basket comprisingof a variety of products. If a basket of products costs Rs. 10,000 inIndia and the same set of products costs $ 200 in USA, the $ will bequoted at Rs. 50 in the foreign exchange market.

The absolute version of PPP can be stated symbolically as :

Pd

e = ---------- where Pd = Price in domestic currency

Pf Pf = Price in foreign currency

e = exchange rate for the foreigncurrency in terms of domestic currency

If the pr ic e in the domestic market r ises relat ive to the pr ice level

in the foreign market, the domestic currency wi l l depreciate

prop ort ion ately against the foreign cu rrency.

In the above example, if the cost of basket increases to Rs.11,000 inIndia, while the price remains unchanged in USA, the $ will now betraded at Rs. 55 to maintain the price parity indicating depreciation ofrupee or equivalent appreciation of $.

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The absolute version of the PPP is based on the unrealistic

assumption of free trade, no transportation costs, no taxes (ordifferentials) and identical commodities (no product differentiation). Transportation cost is a big hurdle in taking advantage of lower

prices in another market as movement of goods and services is notfree. Added to this, the commodities in a basket may not beidentical and may differ in quality.

Further, there are certain goods which do not enter internationaltrade, for ex; housing. Given the above limitations, it is assumed that the exchange rate in

the market may differ from the absolute PPP. Let us assume that when the basket of commodities is Rs. 10,000

in India and $ 200 in the USA, the market may quote Rs. 45 per $.

What is expected is that the exchange rate w il l move alon gwith the relat ive changes in th e prices in the two coun tr ies. If the price of basket increases to Rs. 11,000 in India and it is now

costing $212 in USA, the rupee will suffer a depreciation in relationto $

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The extent to which the rupee will depreciate is the difference in theinflation rates in the two countries during the period. In the aboveexample, assuming that the inflation is 10% in India and 6% in USA,the rupee will depreciate approximately by 4% to quote at about Rs.

46.80. In order to maintain the PPP, the change in the exchange rate

should be proportionate to the change in the relative purchasingpower of the currencies concerned.

New exchange rate Proportionate change in domestic price

--------------------------- = -----------------------------------------------------------

Old exchange rate Proportionate change in foreign price

11,000

------------ x100New exchange rate 10,000

-------------------------- = --------------- = 46.70

45 212

-------x100

200

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Symbolically, this can be stated as :

et (1+ Id) (1+Id)

--- = ----------- OR et = e -----------

e (1+ If) ( 1 + If)

Where et = expected exchange rate after period t

Id = rate of domestic inflation during period t

If = rate of foreign inflation during period t

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et = 45 ------- = Rs. 46.70

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In practice, in the place of basket of products, price indices areused to compute the PPP. Suppose, the price index in India andUSA are 100 and the exchange rate is Rs. 45 a dollar. At the endof the period, the price index in India is 115 and in USA it is 108.the exchange rate will move to Rs. 47.92.

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115

--------et = 100

------- --------- = Rs. 47.92

45 108

--------

100

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2c.purchasing Power Parity Theory

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