Two Different Versions of Purchasing Power Parity Theory

The PPP theory has two versions, namely, the absolute or positive version and the comparative version.

1. Absolute or Positive Version:

In this version, for the period under consideration, an identical bundle of goods and services is chosen, and its aggregate prices found out in the two countries in their respective currencies. Then the ratio of these aggregate prices equals the equilibrium rate of exchange between the two currencies.

As an example, if the cost of the chosen bundle of goods and services in USA is $10 and in India, it is Rs. 400, then according to this version of PPP theory, the equilibrium rate of exchange is $ 10 = Rs. 400, or $ 1 = Rs. 40.

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Limitations:

This version has three limitations:

i. The basket of goods chosen must be such that its contents can be produced in both countries and in fact are produced. This is a very difficult condition to satisfy; particularly because the very purpose of estimating PPP of two currencies is to consider those goods which are traded between the two countries.

It is highly unlikely that each traded good is also produced in both countries. Factually, even “similar” goods are likely to be “differentiated” ones.

ii. There is no objective basis of selecting the basket of goods for the purpose of estimating the purchasing power of two currencies.

iii. Compilation of any series of price index numbers suffers from several difficulties. PPP theory also fails in overcoming these difficulties.

2. Comparative Version:

This version differs from the earlier one in terms of the method of calculating current equilibrium rate of exchange. Here, we take a base period and assume that the rate of exchange between the two currencies was in equilibrium.

And on this basis, the current equilibrium rate is calculated by taking into account the shifts in price levels in the two countries.

Symbolically, let P_h represent the ratio of (price index in current period/price index in the base period) in the home country; and let P_frepresent the ratio of (price index in current period/price index in the base period) in the foreign country. Then, the equilibrium exchange rate as the price of home currency in terms of foreign currency is given by

Base Period Rate of Exchange x (p_f/ p_h). [Formula 1]

And similarly, the equilibrium exchange rate as the price of foreign currency in terms of home currency is given by

Base Period Rate of Exchange x (P_h / P_f). [Formula 2]

For example, if in the base period, one dollar was equal to Rs.30, and then it is assumed to be the equilibrium rate in that base period.

Further, compared with the base period rate, equilibrium exchange rate in the current period moves against dollar with an increase in US prices and a fall in Indian prices, and vice versa.