essentially on the quotient of the internal purchasing powers
of these currencies.”
Thus, according to the purchasing power parity theory, the
exchange rate between one currency and another is in equilibrium
when their domestic purchasing powers at the rate of exchange are
equivalent. E.g. if in India 40 Rs are spent for purchasing 1 kg of
apples and in America for the same kg of apples if one dollar is
needed to spend, then it is clear that the purchasing power of both
currencies is different in their respective nations. In order to make
equivalent these currencies with each others units purchasing
power will be 1$ = 40Rs.
Once the equilibrium is established, the market forces will
operate to restore the equilibrium if there are some deviations. E.g
if the exchange rate changes to 1$ = 42Rs when the purchasing
power of these currencies remain stable, dollar holder will convert
dollars into rupees because, by doing so, they save Rs. 2 when
they purchase a commodity worth $ 1. A change in the purchasing
power of currencies will be reflected in their exchange rates. For
this purpose the price index is made. It is the parity (equality of
the purchasing powers of the currencies which determines the
exchange rate.
If there is a change in prices (purchasing power of the
currencies), the new equilibrium rate of exchange can be found out
by the following formula; ER = Er x Pd/Pf
Where,
ER = Equilibrium exchange rate
Er =Exchange rate in the reference period
Pd = Domestic price index
Pf = Foreign country‘s price index
11.2.1 Two versions of PPP:
1. Absolute Version:
Under this version, the exchange rate between the
currencies of two nations is established at the point where their
purchasing power is equal. It reflects their domestic purchasing
power too. It is calculated as
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