Purchasing Power Parity Theory Economics

Purchasing Power Parity Theory Economics Essay

Purchasing Power Parity Theory Economics


This paper critically evaluates the purchasing power parity theory (PPP) as a model of foreign exchange rate determination. The essay discusses the purchasing power parity theory, its criticism and how it explains the evolution of sterling pound to dollar rates.

The PPP theory is said to have originated in the old School of Salamanca in Spain in the 16th century. The theory is based on the notion that currencies have purchasing power and hence the exchange rate between any two currencies will be influenced by the ratio of collective price level between the two nations (Taylor & Taylor, 2004). Implying that the buying power of a unit of legal system tender will be equal between the two countries. That is if someone converts a local currency into a foreign currency the number of goods that the foreign currency will purchase in that country will equal to the amount of good the domestic currency would have purchased in the domestic market before the conversion. This means that the arbitrage opportunities should not exist whereby one can buy a commodity at lower price in one country and sell at a high price in the other country. Such opportunities will lead to increased demand of goods and currency of the country with low prices adjusting the prices to equilibrium hence the PPP model is based on the law of one price. Though the reference to purchasing power parity theory was made by Riccardo, the theory was popularized by Gustav Kassel after the First World War in 1918 (Akrani, 2010). After the World War I there was a debate on the nominal rate of currency exchange among the industries nations due to the widespread hyperinflation that occurred during and after the war. Some countries had abandoned the gold standard in 1914 when the War started and these countries were experiencing different inflation levels to those that maintained the gold standard.

So of the countries that had abandoned the gold standard were willing to switch back to the gold standard. These developments led to the need of developing a way to determine the exchange rate between different countries. Gustav Cassel suggested the purchasing power parity model as a mean of adjusting exchange rates or parities to those before the First World War for the countries wishing to go back to the gold standard model (Lafrance & Schembri, 2002). Although only a very few economists believe in purchasing power parity theory explanation of short-term exchange rates most believe the PPP model can explain the long run exchange rates (Rogoff, 1996). Though the theory was initially proposed to determine the exchange rates it is currently also used to compare the living standards of different countries.

There is two type ofthe PPPmodels, which include the absolute PPP and relative PPP model.

Absolute Model

This is the simplistic model of purchasing power parity theory and is grounded on a multi-product version of the law of one price(LOP) but in a global setting (Macchiarelli, 2011). According to the absolute version of the theory, the rate of exchange should generally mirror the association between the internal buying power of the different countries units of currency. The theory claims that the exchange rate ought to be equal to the ratio of the price of a set of goods in one country to that of the other country. The absolute PPP theory assumes that there are no trade barriers, transaction cost or even transportation costs availing arbitrage profit opportunities in case of disparities in price levels.

The equation for determining the exchange rate using the absolute PPP concept is;

The rate of exchange (R) between country A and B = [units of currency A/units of currency B] * internal purchasing power of A /* internal purchasing power of B

The internal purchasing power of each currency is substituted with the reciprocal of the general price index as the internal purchasing power is the inverse of price levels.

R= [units of currency A/units of currency B] * [general price index in country B/ general price index in country A]

Further, the units of currency are substituted with the set of commodities since it assumed that the units of currency can purchase an identical basket of commodities.

R= [Q0 / Q0]*[PB/PA]

Where R is the rate of exchange, Q0 is corresponding weights of commodities in the basket, PB the price index in country B and PA the price index of country A.

The absolute model has its weaknesses such as the assumption of free trade, lack of transportation costs and transaction cost between two countries. It has been described as too simplistic and unrealistic in its assumptions. Another shortcoming of this theory is it attempts to measure the purchasing power in absolute terms instead of more correctly relative terms.

The Relative Type of the PPP Model

The relative version of the model postulate that changes in price levels it can be used to explain the changes in the equilibrium rate of exchange between two national currencies. The theory associates the variations in the equilibrium exchange rates to variations in the purchasing power parities of currencies. Meaning that the comparative changes in the price levels in two countries between some specified period or the base period, and the current period influence the rates of exchange between the two countries ‘currencies in the current periods. The relative PPP states that the equilibrium rate of exchange in the base period (R0) and the ratio of price indices of current and base period in one country to the ratio of price indices of current and base periods in the other country determines the equilibrium rate of exchange in the period (R1). Expressed as;

R1= RO* [PB1/ PBO] / [PA1/PA0]

Where R1 is the current rate of exchange between currency A and B, RO is the specified base period rate of exchange, PB the price index in country B and PA the price index of country A.

Apart from having unrealistic assumptions such as the absence of transportation costs, the relative model of purchasing power parity theory suffers from the problem of determining a base exchange rate which is in equilibrium because if that is not the case the current and future rate of exchange determined using the model will all be wrong.

Criticism of the Theory

The PPP theory is one of the most discussed theory in the economics field and has been criticized and scrutinized in equal measure by various economists. Some like Keynes have dismissed it as a trivial truism or untrue due to it strong assumptions which are unrealistic in the practical world. For example, the assumption that there are no barriers to trade, the absence of transportation costs, transaction costs, insurance, and taxes are too unrealistic. It is well known that not only in foreign trade some of the assumptions of PPP theory could not hold even in the domestic market. Such assumptions include the absence of transportation costs.

The PPP theory presumes that there is a direct functional association between the price levels of two nations or the internal buying power of their currencies and the rate forex. In reality, such a direct correlation between the buying power of the two currencies and the exchange rate does not exist. It is evident that other factors besides the purchasing power of the currencies influence exchange rates. The model overlooks these other factors.

The theory determines the rate of exchange by comparing the indices of general price in the two nations or the changes in general price levels for the relative PPP model. As the general price level includes both the prices of domestically and internationally traded goods, the PPP model is based on the implied notion that the prices of these two categories of goods vary equally and proportionately in the same direction in both the countries. However, it observed that it not the case in most of the time making that assumption invalid. The critics of this assumption suggested that only the international mobile and traded goods be the only one included in the calculation of price indices but this proposition was dismissed by Keynes saying that such change would make the business model meaningless.

One of the main criticism against the PPP theory is concerned with the application of price- indices as a mean for calculating the buying power of currencies in different republics. The main problem with price indices is selecting which one to use as they are several price indices in each country. Another difficulty with price index is that they are a sample of commodities which represent the basket of goods consumed in that country which may not be a true representative of the national commodities basket. Also, different countries have different consumption patterns making it difficult to constitute the said national commodities basket as the commodities may not be comparable. Different countries use different methods of constructing price indices such as the use of different base year, different weight, and averaging methods (Isaac, n.d.). It is hence a difficult task to construct a price index, which represents the accurate measure of purchasing power parity of a currency.

The PPP theory suggests that there is a causal association between the change in the price level and the change in the exchange rates has been criticized as invalid. The critics of the PPP theory claims it is possible that variations in exchange rates can cause changes in price level rather than a change in price level causing the change in exchange rate. This is true especially for countries which rely on international trade for example when the domestic currency depreciates the price of imports will increase pushing up the price levels hence the proposition by the PPP theory is faulty and misleading in this case.

The theory is criticized for overlooking capital transactions and only considers the trade of merchandise. The theory can be applied to only those nations that merchandise trade account the BOP is constituted only by the merchandise trade account. Kindleberger was critical of the model saying it was designed for countries who trade only but not for those countries which trade and bank (receive capital inflows). The assumption of zero capital movements between countries is critiqued as being too simplistic and invalid as capital inflows and outflows are important components in the balance of payments and cannot be simply ignored. The impact of large capital flow in developing nations on their exchange rates is well known as they tend to cause or intensify volatility of exchange rates (Ramos, 2012). Additionally, it argued that prices of commodities are not the only factor driving demand and supply of merchandise commodities but also the expectation of exchange influences the people decide on whether to trade and in what direction (Mussa, 1984).

The relative PPP theory is based on assumption that the base rate of exchange was in equilibrium which can be wrong making the whole model wrong despite the price level changes calculations in the two countries being correct (Chand, n.d.). This is a persistent problem since any other rate of exchange base on that the base exchange rate will be wrong causing a permanent error. It is also difficult to identify and determine an exchange rate which is in equilibrium.

The PPP theory is condemned for being a static theory which assumes many factors will remain constant over time which in reality is not valid as most factors changes with time. Some critics of the PPP theory states that the assumption of no structural changes in the factors which underlie the equilibrium in the base period is misleading. They state that such factors as tastes or preferences, productive resources, technology, market sentiment, and other disturbances will usually occur. The assumption related to constancy barter trade terms between two countries is another invalid assumptions since barter trade terms between two countries will vary from time to time due to factors such demand and supply variation of foreign goods and foreign loans (NIRAV, n.d.).

Keynes argues that the PPP theory fails to consider the elasticity of reciprocal demand and only uses the changes in relative price. He claims that the elasticity of reciprocal demand is an important factor in the determination of the rate of exchange. The other factor that is disregarded by the PPP theory is the influence of market forces on the rate of exchange. The main cause of changes in the exchange rate can be directly associated with the supply and demand of the currencies and these forces are influenced by other factors besides the relative price levels. These other factors may include capital flows, cost of the transaction, population change, technological changes, and even government intervention. The PPP theory has also overlooked the impact of income and expenditure on the rate of exchange through affecting the demand and supply of goods. For example, price levels in the developed economies are higher than those in the less developed countries. These variations in income and expenditure are ignored in the PPP theory. The Penn-Balassa-Samuelsson effect states that there high correlation price levels and income levels of economies (L.Brock, 2011). Ragnar Nurkse claims that treatment of demand simply as a function of price, excluding the large variation in the aggregate income and expenditure which occur in the business cycle (due to either force of demand and supply or government intervention) (Anad, n.d.). This can lead to wide changes in the volume of trade hence affecting the value of foreign trade even if prices or price relationships are constant.

The PPP theory is built on the assumptions of free international trade and laissez-faire. This notion is clearly incorrect as it is common practice for the government to intervene in both international trade and domestic trade through actions such as taxes, licensing, quotas and other measures that regulate and control trade and other transactions. The theory is therefore based on wrong assumptions which are far from the reality. The theory can only serve as a crude estimation of the equilibrium rate of exchange with it unrealistic assumption and cannot empirically measure the rate of exchange. Also, it cannot be used in predicting the rate of exchange. The theory is fundamentally wrong when it is followed strictly and loses its value when not strictly followed (Dornbusch, 1985).

The theory is also critiqued for not recognizing the basis on which international trade is built. The theory assumes that both countries can produce similar commodities and can consume similar commodity which is fundamentally wrong as there would be no motivation to encourage international trade between countries. The international trade is based on comparative advantage and geographical specialization in trade. In addition, the theory fails to recognize the change in international trade relationships such entrance of another trading partner of the existence of multiple trade partners and just looks at two trading partners. The PPP theory is therefore too simplistic to determine the rate of exchange in a complex trading relationship including several countries.

The dependence of PPP theory on the law of one price suffers from the fact that not all goods are internally tradeable some goods cannot be exported or imported. For example, Samuelson claims that he cannot import cheap haircuts from Paris either export beautiful scenery Niagara falls to Europe (Samuelson, 1964). The tradeable good affects the price levels but do not provide arbitrage opportunities, for example, it is difficult although not impossible for someone to relocate to a place or a country which has a lower price level. Perfect competition may be necessary for price parity to be observed which also may not always be the case. Presence of imperfect competition is relevant to the failure of PPP theory as it makes it difficult for perfect arbitrage of price to occur. For example monopolies or oligopolies may employ tactics such as price discrimination in segmented markets (Papadopoulos, 2005). Other factors such as different demand patterns also affect the basis of the law of one price for example demand for bacon is high in Germany but low or non-existent in Saudi Arabia.

The PPP theory implies that the real exchange rates do not affect the growth rate of economies which has been criticized as evidence exist to reject this implication and its well known that the exchange rates indeed affect the long-run growth rates (Faria & León-Ledesma, 2000).

The theory is said to be only relevant in the estimation of the long-term rate of exchange but cannot explain the short-run exchange rates variations. This is due to monetary disturbances in the short run period. Its failure to explain either the short-term volatility of the real exchange rate or the excessive persistency(Cheunga & Laib, 2000). Taylor claims his empirical finding provides evidence that in long run the PPP theory is valid and money seems to be neutral in the that period; however, the short run variations can be large and have a close association with short-term monetary shocks suggestive of a role for nominal inflexibilities (Taylor, 2000).

Empirical Studies on the PPP Theory

The PPP theory has been extensively studied with differing conclusions from various scholars. Some have dismissed the theory and concluded that it does not hold while others have claimed that the theory closely explains the exchange rate in the long run but not in the short run. The empirical test to scrutinize the PPP hypothesis has been mainly focused on three are which are;

To test whether the LOP is valid for all traded commodities and whether it is possible to construct price indices which the law of one price can hold. The studies by (Isard, 1977) suggest that disregarding transportation and other costs the law of one price is obeyed by goods which are homogenous or close to being homogenous. However, for goods with little differentiation or those that lack close substitutes the law of one price did not hold and it was difficult or impossible to construct price indices that observe the law of one price. Ritchey (2009) found that wine did not obey the law of one price between Hong Kong and New York (Ritchey, n.d.). However, he found out that the price differences in wine were diminishing in long run an indication that the law of one price may be valid in the long-term rather than in the short-run. The LOP is also rejected by Barzel, who claims that price conveys both explicit and implicit information. The price of products can differ due to implicit information or subjective view of customer toward a brand or reputation making the law of one price invalid since people are will to pay different prices for identical goods due to brand reputation (Barzel, 2007). Barzel postulates that price variations of a tradable good will reduce as information about it quality becomes available. Another empirical testing of the LOP between countries found that most goods between any two European countries were either overvalued or undervalued even after adjusting for income and value-added taxes differences, hence dismissing the law one price proposition (Crucini, et al., 2005).

The next area of the PPP theory is its parameters and have been extensively studied to estimate the estimated general equation of theory and test it parameters to those predicted by the PPP model. Studies indicate that the test of the model fails to agree with the model itself in the short run but they closely matches the model estimates in the long run (Rogoff, 1996). The findings Pippenger and Philips suggest that the law of one price works in commodity markets. Any evidence that real exchange rates have long half-lives is a result of either using price indices of non-identical goods or testing the hypothesizes in a market where price arbitrage is not possible. (Pippenger & Phillips, n.d.). The price level parity theory is found to be deficient in that countries with low income tend to have low prices for the non-tradeable goods such as rent, wage rate, and other services while high-income countries these goods will have high prices. Since the price indices are constructed as the average of both consumed goods it includes both the tradeable and non-tradeable goods, this inflates the price level of high-income economies and deflate those of low-income economies (Kravis & Lipsey, 1983).

The last issue empirically tested on the PPP theory is whether it is an efficient predictor or determine the exchange rate. This area has generated much debate as different scholars have come up with a conflicting conclusion with some supporting the valid while other rejecting the PPP model. The theory was found to hold in studies Pacific islands countries using floating regimes (Jayaraman & Choong, 2014). The study by Mohammed indicates that PPP is valid in the longterm and there is evidence of a causal correlation between the Algerian exchange rate and the major world currencies (Mohammed, 2015).

PPP Theory Explanation of the Evolution of Sterling Pound to Dollar Exchange Rates

The PPP implies that the ratio of price level or rather the rate changes in price level amid two nations defines the exchange rate between the two nation’s currencies. The PPP theory can, for example, explain the cause of GBP/USD to fall to its lowest level in 1985. Using the PPP model we can explain the drastic fall GBP/USD exchange rate to higher price levels changes in the US in the years preceding 1985 due economic stimulation by the Reagan administration. After high inflation from 1979 to 1980, prompted the government to intervene so as to curb inflation and control price level hence the great changes in the price level between the 1980 and 1985.


The PPP theory has its shortcomings and the criticism against this model are valid. But just like most theory strong or unrealistic assumption does not derive it theoretical validity. The PPP theory is still relevant and closely explains changes in the long-term exchange rates. Additionally, it has become a useful tool for policymakers to compare the relative prices levels between different countries.


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