The Purchasing Power Parity principle (PPP) was enunciated by a Swedish economist,
Gustav Cassel in 1918. According to this theory, the price levels (and the changes in
these price levels) in different countries determine the exchange rate of these countries
currencies. The basic tenet of this principle is that the exchange rates between various
currencies reflect the purchasing power of these currencies. This tenet is based on the
Law of One Price.
It also makes a
few additional assumptions.
No transaction costs in the foreign currency markets: It assumes that there are no costs
involved in buying or selling a currency.
Basket of commodities: It also assumes that the same basket of commodities is
consumed in the different countries, with the components being used in the same
proportion. This factor, along with the Law of One Price, makes the overall price levels
in different countries equal.
Though the explanation provided by the absolute PPP is very simple and easy
to understand, it is difficult to test the theory empirically. This is due to the fact that the
indexes used in different countries to measure the price level may not be comparable due
-- the indexes being composed of different basket of commodities, due to different needs
and tastes of the consumer.
-- the components of the indexes being weighted differently due to their comparative
-- different base years being used for the indexes.
Due to these reasons, these price indexes cannot be used to evaluate the validity of the
The relative form of PPP:
The absolute form of PPP describes the link between the spot exchange rate and
price levels at a particular point of time. On the other hand, the relative form of PPP talks
about the link between the changes in spot rates and in price levels over a period of time
reflect the changes in the price levels over the same period in the concerned economies.
Relative PPP relaxes a number of assumptions made by the Law of One Price and the
Absence of transaction costs
Absence of transportation costs
Absence of tariffs.
The relaxation of these assumptions