Purchasing Power Parity (PPP) Theory and Factors Affecting Exchange Rates
1. Genesis & Concept of Purchasing Power Parity (PPP)
The Purchasing Power Parity (PPP) Theory was originally proposed in classical form by British economists (John Wheatley and David Ricardo) and formally systematized into modern economic doctrine in 1918 by Swedish economist Gustav Cassel.
Gustav Cassel’s Core Axiom:
The exchange rate between two inconvertible paper currencies is fundamentally determined by the ratio between the internal purchasing powers of the two currencies in their respective domestic markets.
Equilibrium Exchange Rate Formula:
Equilibrium Rate = (Domestic Purchasing Power of Currency A) / (Domestic Purchasing Power of Currency B)
The theory exists in two distinct formulations: the Absolute Version and the Relative Version.
2. Absolute Purchasing Power Parity & The Law of One Price
The Absolute Version of PPP is built upon the Law of One Price (LOOP).
The Law of One Price:
In an integrated global market with zero transportation costs and no official trade barriers (tariffs or quotas), an identical commodity must sell for the exact same price anywhere in the world when prices are converted into a common currency:
Law of One Price: P_Domestic = E × P_Foreign
(Where E = Exchange Rate in units of domestic currency per 1 unit of foreign currency)
Implied Equilibrium Rate (E): E = P_Domestic / P_Foreign
Example:
Suppose a standardized commercial basket of consumer commodities costs INR 8,400 in India and the identical basket costs USD 100 in the United States:
Example: E = INR 8,400 / USD 100 = 84.00 INR per USD
If the actual market exchange rate were 90.00 INR/USD, the dollar would be overvalued and the rupee undervalued, triggering commodity arbitrage until prices and exchange rates realigned.
3. Relative Purchasing Power Parity (The Dynamic Version)
Because the Absolute version breaks down due to transportation costs, trade barriers, and consumer basket differences, Gustav Cassel formulated the Relative Version of PPP.
Core Principle:
The Relative version does not require absolute price levels to be identical. Instead, it asserts that the percentage change in the exchange rate between two currencies over any time period will equal the inflation differential between the two countries:
Relative PPP Equation:
(E1 - E0) / E0 ≈ Inflation_Domestic - Inflation_Foreign
Variables Defined:
- E0 = Spot exchange rate in base period
- E1 = Expected spot exchange rate in future period
- Inflation_Domestic = Domestic inflation rate
- Inflation_Foreign = Foreign inflation rate
Future Exchange Rate Formula:
E1 = E0 × [(1 + Inflation_Domestic) / (1 + Inflation_Foreign)]
Worked Numerical Problem:
- Current Spot Exchange Rate:
USD / INR = 84.00 - Expected Annual Inflation in India:
6.0% - Expected Annual Inflation in the United States:
2.0%
Calculate the expected spot rate at the end of 1 year using Relative PPP:
Calculation: E1 = 84.00 × [(1 + 0.06) / (1 + 0.02)] = 84.00 × (1.06 / 1.02) = 84.00 × 1.0392 = 87.29 INR per USD
Conclusion: Because India’s inflation rate is 4% higher than US inflation, the Indian Rupee must depreciate by approximately 4% against the US Dollar over the year to preserve relative purchasing power parity.
4. Practical Application: The Economist’s “Big Mac Index”
Created by The Economist magazine in 1986, the Big Mac Index is a globally famous, lighthearted empirical test of Absolute Purchasing Power Parity.
- Why the Big Mac?
McDonald’s Big Mac burger is produced to virtually identical recipe specifications in over 100 countries using standard local labor, bread, beef/chicken, and cheese. - The Test:
Implied PPP Rate = (Price of Big Mac in Local Currency) / (Price of Big Mac in US Dollars)
- Valuation Metric:
- % Over / Under-Valuation = [(Implied PPP Rate - Actual Market Rate) / Actual Market Rate] × 100
- Real-World Finding: In developing nations like India (McAloo Tikki / Maharaja Mac), burgers are consistently priced much cheaper in USD terms than in the US, showing that market exchange rates systematically undervalue emerging market currencies because of cheap non-tradable inputs (local labor and rent).
5. Major Limitations and Criticisms of PPP Theory
While PPP provides an excellent benchmark for long-term equilibrium exchange rates (over decades), it fails dramatically as a short-to-medium term forecasting tool:
- Existence of Non-Tradable Goods & Services:
Haircuts, restaurant meals, real estate housing, and domestic transportation cannot be shipped across international borders for arbitrage. - Transportation Costs & Tariffs:
International shipping freights, import duties, and port clearance fees prevent price equalization. - Dominance of Capital Flows:
Over 90% of global daily forex transactions are driven by financial capital flows (FDI, FPI equity purchases, sovereign bond trading, and currency speculation), NOT by commercial merchandise trade. - Sticky Prices vs. Volatile Exchange Rates:
Consumer prices adjust sluggishly over months, while foreign exchange rates fluctuate violently by the second.
6. Fundamental Macroeconomic Factors Affecting Exchange Rates
In real-world foreign exchange markets, exchange rates are influenced by an interplay of six primary macroeconomic drivers: