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CH: 20 PURCHASING POWER PARITY THEORY
Q1: Critically evaluate the purchasing power parity theory.
ANS: PURCHASING POWER PARITY THEORY:
*INTRODUCTION:
~ Purchasing power parity theory explains the determination of exchange rate. According to the theory, the exchange rate between two currencies in the long run is determined by their respective purchasing powers in term of goods and services in their own nations.
~ The essence of the theory in that under fluctuating market structure, identical goods which are sold in different markets will sell at the same price when expressed in common currency.
*ECONOMISTS:
~ The purchasing power parity theory is attributed to Swedish economist Gustav Cassell.
~ However, its origin dates back to the writings of David Ricardo.
*ASSUMPTIONS:
1) Absence of transport cost.
2) There are no restrictions on trade.
3) Price change at a uniform rate.
*EXPLANATION:
~ Purchasing power parity theory can be explained in two versions:
: Absolute version
: Relative version
A) Absolute version of Purchasing Power Parity theory.
~ According to the purchasing power parity theory (absolute), the identical basket of goods in two different countries must sell for the single price when expressed in the same currency.
~ This indicates that the exchange rate between the currencies of two different countries is decided by their respective purchasing power.
~ Thus, Gustav believes that the purchasing power of two different currencies is to be compared only in terms of basket of goods and services instead of a single commodity.
~ Algebraic formula of the absolute version of purchasing power parity is:-
R=P
P0
Where:
R= exchange rate of domestic currency in relation to foreign currency.
P= price of a basket of goods expressed in domestic currency.
P0= price of a basket of identical goods in foreign currency.
~ According to the absolute purchasing power parity theory, a rise in the domestic price level in relation to the foreign price level will lead to a proportional depreciation of home currency against the foreign currency.
ILLUSTRATION:
A basket of goods consists of 100 items. The basket costs RS: 10,000 in India and US $ 250 in USA.
:. Exchange rate =10000 = 40
250
If the price of the basket increases to Rs: 12500 in India, the new exchange rate = ?
New Exchange Rate =12500 = 50
250
Here, the rupee depreciates, while the US $ appreciates in terms of the rupee.
Limitations of Absolute version of purchasing power parity theory:-
1) The absolute theory suffers from a basic weakness that it compares purchasing power of currencies at a particular point of time. Since purchasing power is a relative concepts, such comparisons are not possible.
2) The absolute version neglects the cost of transporting the commodities which is the most important factor that makes the prices of internationally traded goods differ between countries.
3) The purchasing power parity theory fails to reflect the true purchasing power as it neglect trade restrictions like tariffs and other forms of protection.
B) RELATIVE VERSION OF PURCHASING POWER PARITY THEORY:-
~ According to the relative version of purchasing power parity theory, the exchange rate will adjust by the amount of inflation differential between the two countries.
~ Algebraic formula of the relative version of purchasing power parity theory is :-
R1= R0.P1
P2
Where:
R1 = new equilibrium exchange rate.
R0= equilibrium rate in the base period.
P1= change in the price index in the home country.
P2= change in the price index in other country.
ILLUSTRATION:
~ The price index in India increases from 100 to 300.Whereas in USA, it increases from 100 to 200.
The base period rate = 40, the new exchange rate = ?
R1 = R0 xP1
P2
= 40 x300
200
:. R1 = 60
Limitation of Relative version:
1) The new equilibrium exchange rate depends on the old (base) rate, however there are various difficulties in calculating the correct base rate.
2) Since there are various types of price indices, choosing the most appropriate price index is difficult.
*LIMITATION:
~ The Purchasing Power Parity theory suffers from the following limitations:
1)FAULTY ASSUMPTIONS:
~ The Purchasing power parity theory is based on faulty assumptions like lack of transport costs and lack of trade barriers.
~ Infact, transport costs and trade restrictions certainly influence the exchange rate.
2)NO DIRECT LINK BETWEEN PRICE CHANGE AND EXCHANGE RATE:
~ The purchasing power parity theory assumes that changes in price level results in changes in exchange rate.
~ However, there is no such direct link between price level and exchange rate.
~ A change in price level may not bring about any change in the exchange rate.
3)PRICES DO NOT CHANGE AT A UNIFORM RATE:
~ Purchasing power parity theory assumes a uniform rise or fall in costs or prices. In reality, there are variations in the degree of price charges.
4)IGNORES GOVERNMENT INTERVENTION IN EXCHANGE RATE:
~ The purchasing power parity theory neglects government intervention in exchange rate determination.
~ Normally in case of too much appreciation or depreciation, the central bank intervenes in exchange rate determination to protect the economy from adverse consequences.
5)IGNORES SPECIALISATION:
~ The purchasing power parity theory ignores the effect of specialization on international trade.
~ Countries export those products in which they enjoy superior cost advantage.
~ So purchasing power of currencies for similar basket of goods and services are actually not considered in international trade.
6)IGNORES EFFECT OF CHANGE IN EXCHANGE RATE ON PRICE LEVEL:
~The theory assumes that changes in price level influences the exchange rate.
~ However, the change in exchange rate also influences the price level.
7)LIMITED APPLICATION TO LARGER COUNTRIES:
~ The theory may have more relevance and applicability to small countries like Denmark, Holland, Netherland, Belgium, etc. since a large part of national income comes from international trade. In such countries there is a close connection between exchange rates and price levels.
~ However in larger countries like India, China, USA, etc. the theory has limited application.
CAPITAL TRANSFERS NEGLECTED:
~ The theory takes into account only trade in merchandise.
~ It excludes items such as services, capital transfers, unilateral transfers which makes the theory incomplete.
~ In fact, it is more a balance of trade theory rather than a balance of payments theory.
9)IGNORE QUALITY OF GOODS:
~ The theory ignores the differences in the quality of goods sold in two countries.
~ Due to difference in quality of goods, price equalisation is difficult and hence arriving at an equilibrium exchange rate becomes impossible.
10)IGNORES ELASTICITY OF RECIPROCAL DEMAND:
~ The theory does not consider elasticity of reciprocal demand in the two countries.
~ This will affect the demand differently which in turn will influence the exchange rate.
11)TOO MUCH EMPHASIS ON PURCHASING POWER:
~ The theory places too much emphasis on purchasing power as a determining factor of rate of exchange.
12)IGNORES SPECULATION IN FOREIGN EXCHANGE MARKET:
~ The theory does not consider speculation in foreign exchange market which has a considerable influence on exchange rates.
*CONCLUSION:
~ Although the theory is subject to various limitations, it does have relevance in the long-term.
~ In the long-run, exchange rates are highly influenced by the purchasing power of respective currencies.
~ It enables us to compare the real income level of different countries as against exchange rate purely determined by market forces.
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