What Is The Purchasing Power Parity Theory?


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Nouman Umar answered
The purchasing power parity theory was first stated by John Wheately in 1882. It was restated by David Ricardo. However it was developed on scientific line by Sustav Cassel who is a Swedish economist. According to this theory under inconvertible paper standards, the external value of currency depends on the domestic purchasing power of that currency relative to that another currency. In other words the rate of exchange between two inconvertible paper currencies is determined by the equality of their purchasing power or by their relative price levels. The theory explains the determination of exchange rate and its fluctuations when the countries are on inconvertible currencies. The theory has been presented in two versions the absolute version and the relative version.

According to the absolute version the normal equilibrium rate of foreign exchange between two inconvertible currencies is determined at the point at which there is equality between the respective purchasing powers of the two currencies. In other words we can say that the normal rate of exchange is determined by the ratio of their purchasing powers. Let us suppose a basket of goods purchased in Pakistan at a particular point of time cost rupees 400 and the same basket of goods in England cost 10. If no cost of transportation is taken into account and there are no restrictions on trade then the exchange rate between the two countries shall be rupees 40 =1. The purchasing power of rupees 40 in Pakistan is equal to 1 in England.

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