Purchasing Power Parity Theory

Purchasing power parity theory explains the determination of exchange rate and its fluctuations when the countries are on inconvertible paper standard.

The theory was first propounded by wheat lay in 1802, but the credit for properly developing the theory in the present form goes to Gustav Cassel who gave its systematic statement in 1918.

The theory is based on the fundamental principle that the different currencies have purchasing powers in their respective countries.

When the domestic currency is exchanged for the foreign currency it is, in fact, the domestic purchasing power which is exchanged for the foreign purchasing power. Thus the most important factor determining the exchange rate is the relative purchasing power of the two currencies.

According to the purchasing power parity theory, under the system of inconvertible paper currency, the rate of exchange is determined by the relative purchasing powers of the two currencies in their respective countries.

A country is said to be on inconvertible paper standard when (a) money is made of paper or some cheap metals and its face value is greater than its intrinsic value; (b) the money is not convertible into gold; (c) the purchasing power of money is not maintained at par with that of gold or any other commodity; (d) the currency may not be fully backed by gold or any other metallic reserves; (e) the currency system is nationalistic in the sense that there is no link between the different paper currency systems adopted by different countries.

Under such conditions, the rate of exchange between the two currencies must equalize the purchasing power of both the countries.

The purchasing power parity theory has been defined by different economists in the following manner. According to Cassel. "The rate of exchange between two currencies must stand essentially on the quotient of the internal purchasing power of the currencies."

In the words of G.D.H Cole "The relative values of national currencies especially when they are not on gold standard, in the long run, are determined by their relative purchasing powers in terms of goods and services."

According to Thomas, "The rate of exchange tends to rest at that point which expresses equality between the respective purchasing powers of the two countries. This point is called the purchasing parity."

According the Kurihara, "The theory seeks to explain that under system of autonomous paper standard, the external value of a currency depends ultimately and essentially on the domestic purchasing power of that currency relative to that of another currency."