Purchasing power parity theory
CH: 20 ? PURCHASING POWER PARITY THEORYQ1: 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 p adios max arity theory can be explained in two versions:: Absolute version: Relative versionA) 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=PP0Where: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.