Explain the Purchasing Power Parity Theory

Explain the Purchasing Power Parity Theory.

DEFINITION
When two countries trade with each other there must be a definite exchange rate between them. If both the countries are on gold standard, it will be quite simple to establish an exchange rate. But, if they are under non-convertible paper currency system it will be difficult to determine exchange rate.

PURCHASING POWER PARITY THEORY tries to solve this problem. The theory suggests that the determination of exchange rate should depend on the purchasing power of the currencies in their respective countries.

FOR EXAMPLE If a shirt in Pakistan can be purchased for a hundred rupees, and in Great Britain one pound, the exchange rate will be Pakistan Rs. 100/- is equal to UK £ 1 or 1£ = Rs. 100. In other words the purchasing power of a currency in its own country will determine its external value. The promoter of this Gustav Castle, an economist of Sweden.

ASSUMPTIONS

1. The economic condition of both the countries should be identical, whether good or bad.

2. The rate of exchange should include expenditure on custom tariffs, shipping charges and other duties and taxes. 

3. Those goods and services should be taken into account which are common in production and used in both the countries. 

CRITICISM
1. The theory will not operate in the short run. 
2. The price level of goods and services is taken into account only for two countries, though they may be available in other international markets too where they have the identical prices. 
3. Increase in exports raises the exchange rate, and increase in import reduces the exchange rate. In both cases internal purchasing power of a currency remains unchanged.

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