Those of you struggling with the concept of foreign exchange must have wondered what determines the exchange rate between two currencies. Purchasing power parity is a theory that is highly relevant in explaining this phenomenon.
What factors determine which currency will cost how much in the global market, in terms of other currencies? Well, the purchasing power parity (PPP) theory attempts to explain how rates are determined and how the exchange rate between two currencies at a given time, stands for an equilibrium in the relative prices of commodities in both the countries. Indeed, it indicates towards the establishment of a parity in equilibrium between the relative purchasing power of two currencies.
The theory begins with the law of one price, which states that in order for a market to be called effectively competitive, all identical goods must have the same price. Price, here, is in terms of the economic value of money and not in terms of its face value. It can be stated that a said commodity has the same price in all markets and economies, but the exchange rate is adjusted to suit economic conditions. Let’s take an example of the price of apples in the US and India. Now, assuming you can buy 100 apples for USD 10 and INR 500 in the US and India respectively, the exchange rate would be determined as follows:
500/10 = 50
Therefore, INR 50 = USD 1
To establish parity, the value of USD 1 is the same as INR 50. Here, we can see that irrespective of the face value, the purchasing power of currencies differ. This economic value of a currency is influenced by many factors such as inflation, availability of commodities, etc. An economy experiencing inflationary pressures undergoes a decrease in the value of its currency (the more units of money you pay for a commodity, the less is its value and vice versa). This disrupts its equilibrium in relation to other currencies in the foreign exchange market and therefore, it needs to depreciate its exchange rate to reestablish the equilibrium.
Now, going back to the law of one price, a basket of goods is specified for tracking price levels of various economies whose exchange rates are to be established. By tracking the increase or decrease in the price of this basket, the inflation rate difference between two economies is arrived at. This is the key indicator of the percentage by which the exchange rate goes up or down for any currency in terms of another.
How do You Determine This?
Purchasing power parity is determined by striking a comparison between the exchange rate and the price level of the two economies. The test for the existence of PPP lies in analyzing whether or not the price level and the exchange rate are at an equilibrium. If not, then there is no parity of purchasing power between the two currencies and adjustments in terms of appreciation or depreciation need to be made to establish a uniform exchange rate.
For instance, assume that the current exchange rate between USD and INR is 50 (USD 1 for INR 50). Now take a commodity, say X, and compare the price ratio of X between both countries. Suppose X costs INR 100 in India and USD 5 in the US. Now, after dividing the larger amount with the smaller amount, we get a price ratio of 20, which is not equal to the exchange rate mentioned previously. This means that the purchasing power of INR is higher than what is reflected by the exchange rate, (USD 1 for INR 20 as opposed to USD 1 for INR 50) and a parity can be struck only by appreciating the value of INR in line with the price ratio.
For calculating relative purchasing power parity, the variables involved are time period, spot rate of exchange between the domestic currency and a foreign currency in the given time period, and the price level in the given time period. Using these variables, we can calculate using the following equation:
St / St-1 = (PFt / PFt-1) / (PDt / PDt-1)
St = Spot exchange rate at the end of the time period
St-1 = Spot exchange rate at the beginning of the time period
PFt = Price level in terms of foreign currency at the end of the given time period
PFt-1 = Price level in terms of foreign currency at the beginning of the given time period
PDt = Price level in terms of domestic currency at the end of the given time period
PDt-1 = Price level in terms of domestic currency at the beginning of the given time period
This theory was developed to its most modern form by Swedish economist Karl Gustav Cassel in the year 1918. It is the basis for measuring the economic health of a nation in terms of the exchange rate and its relation to other currencies.