purchasing power parity
ABSTRACT The purpose of this paper is to discuss and critically evaluate the theory and empirical evidence relating to the ‘law of one price’ and the theory of purchasing power parity (PPP). Section I explains the concept underpinning the PPP and the law of one price. Section II involves a critical evaluation of the theory and empirical evidence relating to Section I.
Purchasing Power Parity and the Law of One Price
PPP doctrine has a long history in economics and was propounded in 1918 by the Swedish economist, Gustav Cassel during the international policy debate. PPP was used as a foundation for recommending a new set of official exchange rates after the large scaled inflations throughout and after the World War 1 that would allow for the resurgence of normal trade affairs (Cassel, 1918). This theory has since been widely used and has been promoted as one of the best known model of exchange rate determination in its own right.
PPP states that “exchange rates will adjust to ensure that the prices of goods in different countries will trade at similar prices when expressed in a common currency” (Pilbeam, 2010, p. 289). In other words, a unit of home currency should have the same purchasing power worldwide, at the going exchange rate. This means that a unit of currency in one country should be able to buy and sell a comparable basket of goods at an equivalent amount of foreign currency in the foreign country. An increase of a price level in one country will cause its currency to depreciate in order to maintain PPP. The PPP exists in two forms; absolute and relative PPP.
In its absolute version, the general price level for goods should be the same in every country. A basket of goods in home country should have an equal price in a foreign country for the same basket of goods after converting the exchange rate into a common currency. For instance, a bag of potato which costs $1 in the United States should cost £0.60 in United Kingdom, assuming an exchange rate of
Purchasing Power Parity and the Law of One Price
PPP doctrine has a long history in economics and was propounded in 1918 by the Swedish economist, Gustav Cassel during the international policy debate. PPP was used as a foundation for recommending a new set of official exchange rates after the large scaled inflations throughout and after the World War 1 that would allow for the resurgence of normal trade affairs (Cassel, 1918). This theory has since been widely used and has been promoted as one of the best known model of exchange rate determination in its own right.
PPP states that “exchange rates will adjust to ensure that the prices of goods in different countries will trade at similar prices when expressed in a common currency” (Pilbeam, 2010, p. 289). In other words, a unit of home currency should have the same purchasing power worldwide, at the going exchange rate. This means that a unit of currency in one country should be able to buy and sell a comparable basket of goods at an equivalent amount of foreign currency in the foreign country. An increase of a price level in one country will cause its currency to depreciate in order to maintain PPP. The PPP exists in two forms; absolute and relative PPP.
In its absolute version, the general price level for goods should be the same in every country. A basket of goods in home country should have an equal price in a foreign country for the same basket of goods after converting the exchange rate into a common currency. For instance, a bag of potato which costs $1 in the United States should cost £0.60 in United Kingdom, assuming an exchange rate of