Question

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Discuss in detail the theory of Purchasing Power Parity.? Discuss?

Answer 1

Purchase power parity is a theory that proposes that exchange rate between two currencies are equal to the ration of the purchasing power of the concerned two currencies. Further, the change in exchange rate takes place with the change in purchasing power of the respective currencies. For example, a product is purchase in 2 Euros in the European Union country, but the same product can be purchased in 3 US dollars in the USA.
Then,
Exchange rate between US dollar & Euro = 3/2 = US dollar1.5/Euro or $1.5/1Euro
In ideal scenario when there is no cost involved in the transaction and transportation as well as free exchange between the currencies is readily available, then purchase power parity is more applicable. These costs are also the reasons that draw criticism to the PPP theory. There is a transportation cost involved in the goods that differ in different countries. The prices of one good in different countries are not reflective in the exchange rate. Further, there is a bid and ask spread between the currencies that gives an exchange rate that is different to the rate, achieved by the purchasing power of currencies. The third issue is the application of taxes in the prices of goods and tax rates are different in different countries. As a result, exchange rates are also dependent upon the tax rates on goods. Hence, PPP theory faces different challenges when it is applied in real world scenarios.