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J6.: . lnternationa# Economics
. . . . . . ies will be reflected iQ their The index
. 'i\_change the purchusmg power ot IS a change in
n
1
umoerof pnces may be made use . p . . . rate of exchange can be found
prices (i.e. the power of:he currenctes), the new eq ..... _. .
out by the folJowing formula. "'
-- ..
..,_...

ER = - .,.....: :.:.... -
. Pl .
where
ER :::: Equilibrium
Er = in the reference
p d = Domestic price ex
p = price .index
I ..
Evaluation Although the ppp theory has certain has a number of whacks too.
Demerits The purchasing power is the following criticisms:
\ ., The theory .makes use of the _price index number to measure the changes in rate of
and hence the .theory 'suffers from the various li.tr. itations of the pnce mdex_ number.
'Z , 2. The compositiuu ...,f the incomesmies iri and hence the types ofgoods
and services included in the.hiaex ' ')!.i y--,::m

country, co!!!P,'irisons
on the has is of su.ch index unrealistic. . ---.-
. ....-....... .
3 . 3. The quality of goods and services may vary from country to country. Comparison of prices without
regard to the quality is unrealistic. .
4. The price index. number may include the prices of products which are not internationaHy traded
and hence th.e rate of exchange calculated on tl1e basis of such price indices cannot be realistic.
l; 5. The theory . is rendered further unrealistic by ignoring the cost of transportation in
trade.
s 6. Ano.ther very unrealistic assumption made by the theory is that trade is free from all
barrters. . . -.: ... .. - -_ ....... ...
.. __ b . 7 . . :he .purchasing ignores.the effects of i.lteniational on the
roreign exchange market. Internatwnal capttai may cau h - h h
F I
. . . . se c anges m t e exc ange
rate. orexamp e, If thc;:re ts capital mflow to India from USA th 1 f h . d h
d
d . . ' e supp y o t e dollar an t e
eman 10r rupees mcreases m the fore1gn exchange market c . . . . .
. of the rupee and depreciation in the value of the dollar. , . ausmg an apprecJatwn m the value
8. Another de(ect of the theory is tl1at it ignores the impact of 1 .
F 1 f c
1
anges m the exchange rates on the
pnces. or examp e, 1 , as a result of large capita! inflows to India
1
.
terms of foreign currencies Indian exports may d
1
d ' CUI]'ency apprectates m
.!.!Jsiia may exceed the and may cause a fall an as a result, the supply of goods in
. ( r:;:.l . . m pnces.
_ \:.he theory does not explaiD the demand for the s 1 fJ.o .
. rale is determined largely by demand arld su
1
en the exchange
. ppycon thons h .... .
attentiOn to these aspects proves to be uns t.

' any t eory that oes not pay adequate

a IS actory.
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T
.. Foreign Exchange
. .
. The purchasing power parity theo t
1
t
1
. . .-
J o. : rate . . . ry .s ar s 1 a given rate of but fails to expiain how
that p . h o_f exchan&c IS Thus, the theory us how, with a given rate of ..
exchange, c.
111
purchasmg powers of two currencies affect the -rate. .
11
The theory ts based on the wrong t' 1 l .
. . . . . . . . assump ton t 1at t 1e elashc1 of demand for'exports and im}lorts
tS equal to Untly t.e. lhts theory . . }' j } 'f h . .
__ .
7
-. :a I< on y t . t e exports and 1m ports change m t e samep n
as the change m th1s IS a very rare occurrence. ,
1
2
No satisfactory explanation of sl
1
o t t h . h . . :.' . . h h
_ r erm c .anges m exc ang_e rates 1s provided by t e t eory. ,
t3. The theory goes contrar; to general experience. Critics point out that tl1ere has hardly been any
case wh_en the. rate of exchange between two currencies has been equivalent to the ;atio of.their ... .
purchasmg powers, . : . . .
. . ..
14. Observers maintain that-: the applicability of the PPP theory. is limited.
movements are often ca\ised by by its very nature, is unpredictable. Foreign-exchange
have been viewed to behave similarly' to .asset markets (such. as stock .markets), which
new information quickly and their prices continuously. However,.
power-panty calculations are based on commodity prices (such the constimer price index), . . . .
which respond sluggishly to changing economic circumstances. To the extent that exchange rates .
respond quickly to new information and commoditY prlces respond slowly, deparfure:s fr,om tJ:te
purchasing-power-parity theory will occur. Most eq:momists maintain that other factors. are much
more important than relative price' levels for exchange-rate in the

. .
. . : .
Merits Despite its manydefects and the power exposes some
very, important aspects of exchange rate determination.
1. It indicates the relationship between the
--_.,......;.----" "''"'- -"""' '' " ' . - ... .,., ..
2. lt explains the state of the trade of a country as well as the nature.ofits balance ofpayments at a
particular time. ,.
3 . . Further, the. theory is applicable, to some extent, t9 all saris of monetary standards. .
Empirical Evidence Empiric;ll data present a mixed pictureregardirig validity oftheprit"lhasing
power parity theory. ' ...
PPP and Exchange-Rate Predictions It is pointed out that for many years, the purchasing-
po,;er-parity appeared to operate reasonably well. Although precise exchange"rate based on
purchasing-power-parity calculations were not always accurate, nations having highP.r inflation rates did
at least experience depreciating currencies .. In the. early i 980s, however, even this broke down.
between 1980 and 1983 the US inflation rate was much higher than Japan's and modes.tly
higher than Germany's. Nevertheless, the. dollar appreciated against both the yen and the mark during
this period.
7

PPP and Adjustment in Exchange Rote It is observed altl10t1gh the
parity theory is oflimitcd value in the short run, over a sufficiently long period it is possible'that economic .
forces work to maint<tin purchasing-power-parity levels. One study used .annual data over the
1869- 1984 to estimate the (kgrec to which the dollar/pound exchange rate returns to
Parity equilibrium. Over the course of this period, the estimated speed of adjustment to purchasmg
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. .
.
8: lntlirnational E.corlomics - J
i
.; . Th. neans that 50 per cent of the adjustment '
14 t r year JS I 1
power panty was per cen pe fi
4
5 years and 90 percent of the l
d. . ty occurs a ter '
to war purchasmg power pan Its suggest.that the purchasing-
d
. b th d f 15 years These resu
a occurs Y e en o hange rate if the adjustment
power-parity theory provides a rough approximation of long-run lexc is of little relevance t
. . . . . f h length 10wever, o
process .ts analyzed over many years. A tJme honzon o sue ' .
decision makers.
8
. h ry provided a point of reference for
PPP and Trade . It is found that the purchasing power panty t eo . .
1
idence sb d
the long-run rate in many of the modern exchange rate theories. ev d h
that PPP performs better for those countries that .are geographicaJJy close to eac
0
an. ; ;e e
linkages are high. Moreover, p:pp holds better for traded goods compared to e d ;oo s.
for failure ofPPP may be attributed to heterogeneitY in tpe baskets of goods consJ ere. or dc?n cltikon
f
d. f rt t'on cost and other trade tmpe tments
1
e
o pnce m tees m vanous countries, presence o transpo a I . .
' [f. rfi : k d the volume of global capt tal flows dunng
tan , tmpe ect competition m goods mar et, an mcrease m
t last decades which to sharp deviation from PPP.
9
alan<;.e of Payments Theory _) . . . . . .
The balance of payments theory, also known as the Demand and Supply Theory and_ the
Equilibrium Theory of exchange rate, holds that the rate, under tree market
ts .. Thus, :accordmg
to .. this theory, the price of a currency i.e. the exchange rote, is determined JUSt hke the pnce of ar.y
commodity is determined by the free play ortlle forces o(ifeiTiancrancfiupPfy ----
. r .. fa .. .\X!w.,n .. (o,r ..... depreciates when the
de and falls, in relation to its supply in the foreign exchange market.
emand for and Supply of Foreign Exchange (the extent ..
a 's .currency in fore.!gn marke_t When
the balance of payments is in equilibrium,'thesupply' of alid':demancl for thti,
... . currency __ are ... m . u.al. But whenffierel-s-a __ t .. in the ;f paymentsJ
d'e.termined'mostty.oy the - x ..
supply of the currency its .demand and uses a
., . .. there IS a _and
. . . rcauses:a the eXtP.ma} .
The demand for arises from demand for f<2[!tSE. .. ... services,
etc. and the s_upply of foreign exchange comes from the foreign demand for the goods,
services, financial assets etc. . .. - ....,. , ..... _. J - ... ... .
In figures D represents the demand for foreign exchange and S for the supply foreign
exchange. At pointE and demand are equal and, E represents the equilibrium rate
of If the aemand shtfts to D
1
__ (figurel8.2), . the exchaii'ge .. iafe- :RJllnd if the
demand falls to D2, the falno R
4
. Figure 18.1 shows the effect changes in on the
. exchange rate.