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Foreign Exchange rate

What is mean by purchasing power parity theory whch is widely considered as kind of foreign exchange rate?


The purchasing power parity theory has been popularized during the inter-war (world war 1, year 1918) period by Gaustav cassel, the swedish economist. Also, called PPP Theory widely.

According to this theory, rates of exchange between two countries are determined by relative price level. The actual rate of exchange must be such that same amount of purchasing power should be same in both countries.

For e.g. If by spending NPR 110/- we can buy an amount of goods in Nepal as we can buy with USD 1/- in America will be NPR 110/- to USD 1/-. Hence, the rate of exchange determined in relation to price level is known as purchasing power parity.

(Source of image is internet)


Determination of exchange rate under PPP Theory

The PPP Theory is determined by comparing general price level. Note, not the price level of internationally traded goods. Prices of exports and imports must remain at the same level in every country tariffs etc. 

Moreover, they are often the result of changes in exchange rates. Hence, it is easy to verify the theory by comparing wholesale standards.

In two version this theory is elaborated:

a) Absolute Version: In this version, the exchange rate between two currencies should reflect the relation between the international purchasing power of various currencies. Making it more simple, the exchange rate would be determined at the point where the internal purchasing power of respective currencies get equalized.

For e.g. Basket of goods cost NPR 1600/- in Nepal and IC 1000/- in India. It means the exchange rate would be NPR 1.6/- = IC 1/-.

Thus, to conclude the absolute version of this theory states that purchasing power of respective currencies does play a vital role in determining the equilibrium exchange rate.

b) Relative Version: The relative version was put forward by Gustav cassel in order to find the strength of changes in the equilibrium exchange rate. Any deviation form the equilibrium will lead to the disequilibrium.

It can take place due to changes in the internal purchasing power of a particular currency. The changes in purchasing power are measured eith the help of domestic price indices of the respective nation.

We need to assume any past rate of exchange as base exchange rate in order to know the percentage change in exchange rate. If we compare the pric indices of the past i.e. base period with that of present period, the new equilibrium exchange rate could be found.




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