How do you determine the exchange rate between two separate currencies at any given time? What factors determine which currency will cost how much in the global foreign exchange market in terms of other currencies? Well, the Purchasing Power Parity (PPP) theory attempts to explain how rates are determined and how the exchange rate between two currencies at a given time stands for an equilibrium in the relative prices of commodities in both countries. Indeed, the term purchasing power parity indicates towards the establishment of a parity of equilibrium between the relative purchasing power of currencies of two countries. PPP determines the exchange rate between two currencies after determining the purchasing power or value of money of both currency with relation to a specific commodity in a specific quantity. Confused already? Well, let's get to the brass tacks then and make an attempt to understand the details of this theory.
What is Purchasing Power Parity?
The PPP theory begins with the law of one price which states that in order for a market to be called effectively competitive, all identical goods must have the same price. Price, here, is in terms of the economic value of money and not in terms of the face value of money. Here, it can be stated that a said commodity has the same price in all markets and economies but the exchange rate is adjusted to suit economic conditions. For instance, let the commodity in question be apples and let the currencies in question be USD and INR. Now, assuming you can buy 100 apples for $10, then we can buy the same number of apples, i.e: 100 apples for RS. 500, the exchange rate would be determined as follows:-
500:10 = 50:1
Therefore, Rs. 50 = $1
Hence, the value of USD ($) 1 in terms of INR would come at (Rs.) 50.
Therefore, to establish parity, the value of USD 1 is the same as INR 50. Here, we can see that irrespective of face value, the purchasing power of different currencies differ. This economic value of a currency is influenced by many economic factors such as inflation, availability of the commodities, etc. An economy experiencing inflationary pressures undergoes a decrease in the value of its currencies (the more units of money you pay for a commodity, the less the value of the money and vice versa). This disrupts its equilibrium or purchasing power parity with relation to other currencies in the foreign exchange market and such a currency needs to depreciate its exchange rate to re-establish the equilibrium. This means that during internal inflation, similar to all other commodities, foreign exchange also becomes costlier in terms of the domestic currency.
Now, going back to the law of one price, a basket of goods or commodity bundle is specified for tracking and comparing price levels of the economies whose currency exchange rates are to be established. By tracking the prices and the rate of increase or decrease in the prices of this basket of goods, the inflation rate difference between two economies is arrived at. This inflation rate difference is the key indicator of the percentage by which the exchange rate goes up or down for any currency in terms of another.
How to Determine Purchasing Power Parity?
Purchasing power parity is determined by striking a comparison between the exchange rate and the price level of the two economies whose currency participates in such an exchange. The test for the existence of purchasing power parity lies in analyzing whether or not the price level and the exchange rate are at an equilibrium. If not, then there is no parity of purchasing power between two currencies and adjustments in terms of deliberate appreciation or depreciation needs to be made to establish a uniform exchange rate.
For instance , assume that the current exchange rate between USD and INR is 50 ($1 for Rs. 50). Now pick any commodity, say, X, and compare the price ratio of X between both countries. Suppose X costs Rs. 100 in India and $ 5 in USA. Now, after dividing the larger amount with the smaller amount, we get the price ratio 20 which is not equal to the exchange rate mentioned previously. That means that the purchasing power of INR is higher than what is reflected by the exchange rate ($1 for Rs. 20 as opposed to $1 for Rs. 50) and a parity can be struck only by appreciating the value of INR to come close to the price ratio.
How to Calculate Purchasing Power Parity?
For the calculation of purchasing power parity, the variables involved are time period, spot rate of exchange between domestic currency and a particular foreign currency in the given time period and the price level in the given time period. Using these variables, purchasing power parity can be calculated using the following equation:-
St / St-1 = (PFt / PFt-1) / (PDt / PDt-1)
Where,
St = Spot rate in the given time
PFt = Price level in terms of foreign currency in given time period
PDt = Price level in terms of domestic currency in given time period
The purchasing power parity theory works on the assumption that the law of one price prevails in competitive markets, excluding the values of transportation and transaction costs. This theory was developed to assume its most modern form by Swedish economist Karl Gustav Cassel in the year 1918. This is a theory of international economics which is the basis of a lot of economic calculations and adjustments for the purpose of comparing international currencies, for conducting trading relations and for measuring the economic health of a nation in terms of its currency exchange rates with relation to other currencies.
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