Topics: Exchange rate, Purchasing power parity, Foreign exchange market Pages: 7 (2359 words) Published: May 18, 2013

Joanna Wazny
University Of The West Of Scotland

Purchasing power parity
Purchasing power parity theory is used to examine and contrast different Currency. Purchasing power parity (PPP) is the economic concept and the method used for determining the comparative value of currencies, evaluating the sum of adjustment required on the exchange rate between states sequentially for the exchange being equal to (or on par with) purchasing power of every currency (Balassa, 2004). This theory asks how much capital would be required for purchasing the similar goods and services in 2 states, and utilizes that to estimate the implicit foreign exchange rate (Redding, 2000). By means of that purchasing power parity rate, the amount of capital therefore has the similar purchasing power in different states. Amongst other uses, PPP rates make possible global evaluation and contrast of profits, as marketplace exchange rates are frequently unstable, are influenced by political as well as financial factors which don’t cause direct changes in income and are liable to methodically minimize the standard of living in under-developed states (Patel, 2000).

The theory of purchasing power parity may be divided into 2 types namely: ➢ First is the theory of absolute purchasing power parity ➢ Whereas the other one is relative purchasing power parity theory The formula of the absolute purchasing power parity theory is S = P / P*,

Where S is the exchange rate, P and P* stand for the level of regional and foreign price of the same collection of products in that order (Mark, 1995). The absolute PPP indicates that when the level of domestic price raises comparatively, the domestic currency’s purchasing power falls down consequently (Alan, 2004). That is, the currency diminishes and the exchange rate declines, and on the contrary. Whereas the formula of the relative purchasing power parity theory may be based on the formula mention below: %△S = %△P - %△P*,

Where %△S is the rate of variation in the exchange rate, %△P and %△P* are the domestic and foreign inflation rate correspondingly (Redding, 2000). Relative PPP states that the exchange rate’s change rate equals the difference between the domestic and foreign inflation rate. If compare Relative PPP with the absolute purchasing power parity, the relative PPP is more valuable, and its information is easy to get (Abuaf, 2006). In a nutshell, the PPP theory is the most important exchange rate determination theory, and it is derived from the quantity theory of money, interpret the exchange rate behavior from the quantitative standpoint. Furthermore, the theory begins to analyze the problem from the fundamental function of money (purchasing power), and is simple to recognize. The formula is easy also (Yoonbai, 2009). However, the purchasing power parity theory is not a comprehensive idea of exchange rate determination. This theory doesn’t shape the cause-effect relations between the price and the exchange rate in a clear way (Abuaf, 2006). The thought that the same items in different states must have the similar "actual" prices is extremely instinctively attractive- in spite of everything, it stands to reason that the consumers must be capable to put up for sale any item in single state, exchange the money got for the item for currency of another state, and after that purchase the similar item back in the other state (and not have money available at all), if for without any reason than this situation only puts the customer back accurately where it began (Alba, 2010). This idea, called purchasing-power parity (and occasionally referred to as purchasing power parity), is just the concept that the amount of purchasing power which consumers have does not rely on what currency it is making purchases with.

Purchasing power parity; not a practical concept
Instead of its instinctive...
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