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Foreign currency is demanded by the people because it has some purchasing power in its own nation. Also domestic currency has a certain purchasing power, because it can buy some amount of goods/services in the domestic economy. Thus, when home currency is exchanged for any foreign currency, in fact the domestic purchasing is being exchanged for the purchasing power, because it can buy some amount of goods/ services in the domestic economy. Thus, when home currency is exchanged for any foreign currency, in fact the domestic purchasing power is being exchanged for the purchasing power of that foreign currency. This exchange of the purchasing power takes place at some specified rare where purchasing of two currencies nations gets equalized. Thus, the relative purchasing power of
the two currencies determines the exchange rate. The exchange rate under this theory is in equilibrium when their domestic purchasing powers at that rate of exchanges are equivalent e.g., Suppose certain bundle of goods/ services in U.S.A. costs U.S. $ 10 and the same bundle in India costs, Rs. 450/- then the exchange rate between Indian Rupee and U.S. Dollar is $1 = Rs. 45. Because this is the exchange rate at which the parity between the purchasing power of two nations is maintained. A change in the purchasing power of any currency will reflect in the exchange rates also. Hence under this theory the external value of the currency depends on the domestic purchasing power of that currency relative to that of another currency.
In this equation 'P' i.e. prices are related to the respective bundle of goods with same weights assigned in both the countries. Thus, the above equation explains that the equilibrium exchange rate is determined by the ratio of the internal purchasing power of foreign currency and domestic currency in their own countries. Thus, to conclude the absolute version of this theory maintains the the absolute version of this theory maintains that the absolute purchasing
power of respective currencies does play a vital role in determining the equilibrium exchange rate.
Thus, according to the equation when the price level in concerned nation changes, automatically the internal purchasing power of the currency of that nation goes on changing. This change leads to the change in the equilibrium exchange rate. Thus, under this theory Gustav Cassel has tried to link the purchasing power of two currencies in determining the equilibrium exchange rate. However, it has been criticized on the following grounds.
1. Limitations of the Price Index : As seen above in the relative version the PPP theory uses the price index in order to measure the changes in the equilibrium rate of exchange. However, price indices suffer from various limitations and thus theory too. 2. Neglect of the demand / supply approach : The theory fails to explain the demand for as well as the supply of foreign exchange. The PPP theory proves to be unsatisfactory due to this negligence. Because in actual practice the exchange rate is determined according to the market forces such as the demand for and supply of foreign currency. 3. Unrealistic Approach : Since the PPP theory uses price indices which itself proves to be unrealistic. The reason for this is that the quality of goods and services included in the indices differs from nation to nation. Thus, any comparison without due significance for the quality proves to be unrealistic. 4. Unrealistic Assumptions : It is yet another valid criticism that the PPP theory is based on the unrealistic assumptions such as absence of transport cost. Also it wrongly assumes that there is an absence of any barriers to the international trade. 5. Neglects Impact of International Capital Flow : The PPP theory neglects the impact of the international capital movements on the foreign exchange market. International capital flows may cause fluctuations in the existing exchange rate. 6. Rare Occurrence : According to critics, the PPP theory is in contrast to the Practical approach. Because, the rate of exchange between any two currencies based on the domestic price ratios is a very rare occurrence. Thus, the PPP theory is criticized on the above grounds.
Thus, Gustav cassell's attempt to explain the exchange rate determination based on domestic price indices was very unique attempt.
Business Foundations advises foreign companies and investment guarantors on evaluation and management of industry-specific political and economic risks in India. Many foreign investors find that, frequently, they have little or no control over external events which can adversely affect the commercial viability of their investments and future business plans in India. These developments include:
slow-down in government decisions due to political instability adverse changes or unpredictability on foreign investment, import, ownership, pricing or tax issues
cultural problems, delays or legal disputes due to local partners and suppliers labour unrest and industrial action disruption of normal business due to social and political unrest corruption and bureaucratic inefficiency unexpected delays and cost-overruns due to overlapping governmental jurisdiction fluctuation in interest, inflation and currency rates
Political Risk Analysis involves the study of these and other external sources of risks, and to evaluate their likely impact on specific businesses and projects. The purpose of Political Risk Analysis is to identify, analyze and predict major risks before actual investment or commitment, and to offer risk-minimization strategies and options. Political Risk Analysis provides senior company executives with a comprehensive set of determinants -- political, economic, cultural or market related -- that may influence their business, both in the short and long term, and gives them an advance look at how existing trends will likely interplay and result in positive or negative outcomes. Business Foundations has successfully advised many foreign investors in this area, including: 1) Large Consumer Products Company (USA): With worldwide sales in excess of $ 7 billion, this company is the undisputed global leader in direct-selling. Business Foundations evaluated potential political opposition to its entry in India, and studied local social and cultural barriers to direct selling. 2) Multi-Client Pharmaceutical Group (USA): Business Foundations has assisted this group, the largest and most active of its kind in the world, in closely monitoring, analyzing and predicting changes in government policy and political attitude towards multinational pharmaceutical companies in India, and has advised it on political aspects of the national debate over new product patent laws. 3) Mid-Sized Medical Products Company (Denmark): Business Foundations has evaluated long-term potential business risks in this sector arising out of developments in healthcare policy and NGO activism. 4) Large Industrial Conglomerate (Japan): Business Foundations has briefed top-level executives on near-term political scenarios, policy forecasts and overall country risks. 5) Business Foundations also publishes India Focus, a bi-monthly political risk report (covering Indian politics, policy, business, diplomacy and social issues) which goes out to over 150 subscribers and readers.