PPP: Enlightening In Theory, Confusing In Practice

PPP: Enlightening In Theory, Confusing In Practice

Introduction

The term purchasing power parity is the technique of determining the relative of different currencies. It is used to estimate the amount that is required to be adjusted on exchange rate between countries for the purpose of keeping the exchange at par with purchasing power of each country. The term was introduced in the mainstream economic discussion during the first quarter of last century, although the concept of purchasing power parity can trace its roots to several centuries ago. The theory of purchasing power parity (PPP) states that the nominal exchange rate between the currencies of two countries is equal to the ratio of the purchasing power of the two currencies (Taylor, 2001, pp.473-498).

The purchasing power of the currency of a country is demonstrated in the price levels of the same, and cash price of a standard basket of consumer goods. The currency of a country with a high level of prices has a low purchasing power (high cost of living). The theory of PPP requires that a lowering of the purchasing power of the national currency, as measured by an increase in the domestic price level, corresponds to a proportional decrease in the value of the currency in the foreign exchange market and symmetrically to an appreciation of purchasing power of money, a proportional appreciation of the same (Rogoff, 1996, pp. 647-67).

Since many years, there has been an ongoing debate over the role of purchasing power parity in determining the exchange rates. Although theoretical work argues that exchange rate should be linked with the relative price levels, but there are many factors that pose a real challenge for the theory in question to hold. Consequently, it can be argued about PPP that it is “enlightening in theory, confusing in practice. This paper aims at concept of PPP, it emergence in the mainstream international economic landscape, and the challenges it faces. The paper also discussed some major factors due to which the implementation of PPP has, so far, become extremely difficult (Taylor, 2001, pp.473-498).

Background

In the second half of the eighteenth and early nineteenth century, the Swedish, French and English propositions presented on purchasing power parity. During the nineteenth century the main approaches to the purchasing power parity were developed by John Wheatley (1807) and David Ricardo (1821) as an extension of the quantity theory of money in economics, which started a new debate in the scholarly world. The most notable criticism came, in particular, from George Goschen (1861) and Alfred Marshall (1975).

However, Gustav Cassel, Swedish economist of the twentieth century, was the first to develop, in a systematic way, the different aspects of the theory of purchasing power parity. G. Cassel turned the purchasing power parity in paradigm, presented it as a challenge the orthodoxy of the gold standard, and had conducted a theoretical analysis involving operational empirical tests that were quite advanced for the time (Cassel, 1933). In essence, the theory developed by ...