Question

Examine how the purchasing-power parity theory determines exchange rates and their implications on trade and job creation in the country

Answer 1

The concept of purchasing power parity (PPP) has two applications in economics. The first use is as a conversion factor to transfer data from denomination in one national currency to another. The data are generally in a national accounts framework, but the level of detail can range from the gross domestic product (GDP) itself to highly disaggregative categories of expenditure. This use of PPP boasts a body of theory (mainly index-number theory) and applications (predominantly to intercountry comparisons of GDP and its components) that have steadily improved over the years, and pathbreaking studies in the area continue to appear.1 There is now general recognition that, for certain purposes of data conversion, it is preferable to use PPPs rather than current exchange rates.

The second application of PPP has no such widespread acceptance among economists. The reference here is to the PPP theory of exchange rates, which has remained a relatively unsophisticated theory, hardly advanced in complexity over three fourths of a century. Yet the PPP approach is resurrected from time to time, ushering in a period distinguished both by empirical applications and renewed criticisms of the theory, whereupon again the approach falls into disuse. Lutz (1966, pp. 13–14) notes that, in spite of its limitations, “the purchasing-power-parity theory … still has many supporters especially among journalists and among government and international officials.” He refers to “the apparently indestructible popularity of this theory.” It is this second application of PPP, its use as an exchange rate theory, that is the subject of this review article. Sections I and II explore conceptual issues of PPP, while Sections III and IV consider its empirical aspects. Section V presents conclusions of the review and offers suggestions for further research in the area.The concept of purchasing power parity (PPP) has two applications in economics. The first use is as a conversion factor to transfer data from denomination in one national currency to another. The data are generally in a national accounts framework, but the level of detail can range from the gross domestic product (GDP) itself to highly disaggregative categories of expenditure. This use of PPP boasts a body of theory (mainly index-number theory) and applications (predominantly to intercountry comparisons of GDP and its components) that have steadily improved over the years, and pathbreaking studies in the area continue to appear.1 There is now general recognition that, for certain purposes of data conversion, it is preferable to use PPPs rather than current exchange rates.

The second application of PPP has no such widespread acceptance among economists. The reference here is to the PPP theory of exchange rates, which has remained a relatively unsophisticated theory, hardly advanced in complexity over three fourths of a century. Yet the PPP approach is resurrected from time to time, ushering in a period distinguished both by empirical applications and renewed criticisms of the theory, whereupon again the approach falls into disuse. Lutz (1966, pp. 13–14) notes that, in spite of its limitations, “the purchasing-power-parity theory … still has many supporters especially among journalists and among government and international officials.” He refers to “the apparently indestructible popularity of this theory.” It is this second application of PPP, its use as an exchange rate theory, that is the subject of this review article. Sections I and II explore conceptual issues of PPP, while Sections III and IV consider its empirical aspects. Section V presents conclusions of the review and offers suggestions for further research in the area.