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Purchasing power parity theory

A theory which states that the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent. For example, the rate of exchange of £1 = $1,70 would be in equilibrium if £l will buy the same goods in the U.K. as $1,70 will buy in the U.S. If this holds true, purchasing power pari ty exists. The theory has its source in the mercantilist writings of the seventeenth century, but it came into prominence in 1916 through the writings of the Swedish economist, Gustav Cassel (1866-1945). The basic mechanism implied by the theory is that, given complete freedom of action, if $1,70 buys more in the U.S. than £1 does in the U.K., it would pay to convert pounds into dollars and buy from the U.S. rather than in the U.K. The switch in demand would raise prices in the U.S. and lower them in the U.K., and at the same time lower the U.K. exchange rate until equilibrium and parity are re-established. Cassel interpreted the theory in terms of changes in, rather than absolute levels of, prices and exchange rates. He argued that the falls in the foreign exchange markets in the post-war period were a result of inflation due to unbalanced budgets increasing the quantity of money. In practice, the theory has little validity, because exchange rates, which are determined by the demand and supply of currency in the foreign exchange markets, are related to such forces as balance of payments disequilibria, capital transactions, speculation and government policy. Many goods and services do not enter into international trade, and so their relative prices are not taken into account in the determination of the exchange rate. Moreover, it is impossible to measure satisfactorily what purchasing power a currency in one country has relative to that in another because of the difficulty of determining the appropriate mix of commodities, and also of measuring their average price level. This means that international comparisons of standards of living, etc., based on current exchange rates have to be interpreted with great care.

Reference: The Penguin Dictionary of Economics, 3rd edt.