S. dollar. If the same mobile phone cost 1000 dollars in U.S., American consumers would buy it from India. When large volumes of such mobile phones were purchased from India by American customers, the price of rupee will go up until one dollar equals 25 Indian rupees.
Purchasing power parity (PPP) theory can be divided into two different categories; absolute PPP and relative PPP. Absolute PPP is based on the belief that without international barriers, consumers will shift their demand to wherever prices are lower whereas relative PPP is based on the notion that market imperfections (tariffs, transportation costs, etc), prices of the same products need not be same in different countries when measured in a common currency Madura, 2009, p. 214-215) In economics inflation refers to the rise of prices of all the goods except the money. The values of the currencies of countries with higher inflation would be less compared to the values of countries with lower inflation as the purchasing power of the consumers will be lessened by the increase in prices in countries with higher inflation.
The rationale behind PPP theory is that when inflation occurs at a higher level in a particular country, foreign demand for goods from that country would be decreased whereas demand for foreign goods from that country should increase and subsequently, the home currency of that country will weaken. The currency depreciation will continue till the foreign country’s goods are no more attractive than the domestic goods (Relationships Among Inflation, Interest Rates, and Exchange Rates, n. d, p.107)
In order to check whether PPP exists, it is better to choose two countries and compare the differences in inflation and the exchange rate change different periods. If the exchange rate changes are in accordance with the PPP theory, then we can safely conclude that PPP exists. The major limitation in testing PPP is that based on the periods chosen, results can vary. The periods