Price Parity: Index Number Problem:

One set of limitations of PPP is statistical in nature, relating to the method of computing the parity itself.

Pigou noted that actual price Indices are calculated from individual prices of only a sample of commodities rather than all commodities in the economy.

Therefore, .my computed price parity is an imperfect representation of the true theoretical parity.

A related difficulty is present even if the entire population of commodities is used to construct the price measure in each country. The value of parity will, in general, depend on the kind of price level (or price index) selected. In other words, the parity will vary with the weighting pattern of the price measure.


Keynes was the first to point out that a PPP calculated from traded goods prices alone is close to a truism drawing the implication that WPls (wholesale price index) are a poor basis for computing PPP. The reason is that such indices are heavily weighted with traded goods and therefore relative price parities calculated from these indices come close to the exchange rate, resulting in spurious verification of the theory.

Keynes observation led subsequent observers to recommend against calculating parities with price indices weighted entirely or heavily with internationally traded goods and, in particular, to rejected export and import price indices and WPIs for this purpose. Yeager rejects absolute PPP as non-operational.

Absolute Parity:

Criticisms of absolute price parity fall neatly on to two categories:

(i) Those that suggest a reduced accuracy with which the short run equilibrium exchange rate approaches the PPP, without refuting the proposition that this tendency exists; and


(ii) Those that deny the basic premise of PPP theory, namely, that a freely floating exchange rate lends to the PPP. The first group of criticisms can be incorporated within the existing framework of PPP theory and indeed some are admitted modifications of the theory according to its proponents. The second group is incompatible with PPP as it stands if these criticisms are correct, fundamental changes in the theory are needed to preserve its validity.

The existence of tariffs and transport costs may be expected to give rise to a deviation of the short-run equilibrium exchange rate from the PPP, the amount of this deviation varying directly with the severity of imperfections. In particular, when trade restrictions take the form of sufficiently high and comprehensive tariff walls, quotas or exchange control, a freely floating (or any maintained) exchange rate may beat virtually no relationship to the PPP, because the price responsiveness of imports and exports is greatly reduced.

PPP becomes all the more inapplicable if controls are extended to the domestic sector in the form, for example, of price and wage controls, rationing of consumer goods and industry allocation of raw materials and primary factors of production. Under these conditions, the buying power of country’s currency is but poorly reflected in the market prices.

PPP theory emphasizes the role of prices in exchange rate determination; yet incomes are so relevant. Yeager counters this criticism by arguing that deviations of the exchange rate from the PPP owing to income forces will bring about price determined trade flows to reduce the deviations. Further, he notes, movements in prices over the business cycle tend to correspond to movements in income. A point overlooked by Yeager is that PPP represents the long-run equilibrium exchange rate, which should not be responsive to cyclical variations in income. So the neglect of income considerations cannot be considered a fundamental weakness of the theory.


The existence of non-current account items is a well known limitation of PPP theory. Cassel himself assigned a role to both short- Min speculation and long-run capital movements as determinants of the short-run equilibrium exchange rate. Others see long-term capital flows as influencing exchange rate long-run equilibrium as well. Again, the, impact of this factor on the PPP theory is a function of the Magnitude and persistence of the flows involved.

To have a long-run Impact on the exchange rate, the flows must persist in significant magnitude. Finally Yeager notes again that a deviation of the actual exchange rate from the PPP, caused now by capital movements, will live rise to the corrective force of price-induced trade flows.

A criticism of a different nature is that PPP views the exchange rate is the determined variable and price levels as causal variables, whereas there are also chains of causation running from exchange rates to prices. Among them are Keynes, Whittaker, Machlup, samuelson and Balassa.

Yeager presents the most creditable defense of the theory against is criticism, lie declares that mutual causation of exchange rates and prices is compatible with PPP theory providing that the line of causation is stronger from price levels to the exchange rate, which he argues is true under normal circumstances. A point in his favour overlooked by Yeager is that influences of exchange rate on price levels are generally short-run in nature, whereas the PPP theory asserts I hat price levels are long-run determinants of the equilibrium exchange rate. It is also clear that the mutual causation criticism would be less applicable to a cost than to a price parity.

Pigou was the first to criticize absolute price parity on the grounds that, if one decomposes the general price level of each country into the price level of non-traded and that of traded commodities, there is no reason for the ratio of the former component of price level to the latter to be the same in each country. Pigou and latter Ellsworth quoting Pigou approvingly reject absolute PPP for this reason.

Relative Parity:

Relative price parity has one problem that absolute parity avoids; base period is required for calculating relative parity. Ideally the base- period exchange rate should be in long-run equilibrium. The base- period exchange rate may have been in disequilibrium and the relative price parity perpetuates this disequilibrium. The difficulty of finding a “normal” or equilibrium base period is sometimes viewed as so overwhelming that the theory becomes virtually unusable, a position taken by Bunting and Bacha and Taylor.

Remaining criticisms of relative price parity center around the fact that economic conditions may have changed in some manner since the base period. The great advantage of relative over absolute PPP is that relative parity is not affected by the various limitations and biases of absolute parity, providing that these factors are invariant from the base to the current period.

One condition that may have changed is the height of trade restrictions and the level of transport costs. Beginning with Pigou, many have mentioned this deficiency of relative price parity one condition that many have changed is the height of trade restrictions and the level of transport costs. Conditions determining international capital flows, unilateral transfers and investment income may have changed since the base period. Structural changes in the economies may produce a relative price parity that would diverge from the absolute parity for the current period and therefore from the long-run equilibrium exchange rate.

The implication for relative PPP that the base period should be as close as possible to the current period in order to minimize the scope for structural changes, as first indicated by Bunting. The problem with this prescription is that it may conflict with the requirement of selecting a base period in which the exchange rate is in (or close to) long-run equilibrium. Thus the “ancient history element in comparative version parity calculations” (Yeager) is perhaps the principal defect of the theory.

Cost Parity:


Criticisms of the cost parity theory fall into two groups: those that point out the weaknesses of cost parity in comparison to price parity concept; and those that concentrates attention on the UFC parity. An early critic of the general idea of a cost parity is Haberler. He sees cost parity as having all the problems of price parity and the additional disadvantage of being vague and ambiguous arguing that “cost level” or “level of cost of production” is a price level of a set of prices that is not clearly defined. Replacing cost parity by wage parity is no solution, he argues, because allowance would still have to be made for other factors of production. Also a relative wage parity would require that changes in the productivity of labour be incorporated into the measure.

Finally, there is the problem of the availability of data. Information on factor prices and productivity is less comprehensive if available at all than is information on product prices. With the possible exception of wage data, this statement remains true today.

Basic Defects of PPP Theory:

Before developing the “balance-of-payments theory” of exchange rates, Keynes suggested two basic defects of the parity theory, namely,


(i) Its failure to take into consideration the elasticities of reciprocal demand, and

(ii) Its failure to consider the influence of capital movements.

In Keynes’ view, foreign exchange rates are determined not only by price movements but also by capital movements, the elasticities of reciprocal demand, and many other factors affecting the demand for and supply of foreign exchange.

The Elasticities of Reciprocal Demand:

By elasticity of reciprocal demand is meant the responsiveness of one country’s demand for another country’s exports with respect to price or income. As for price elasticities of demand Tor exports, the price change which is relevant here might be considered to be due to exchange depreciation or appreciation not to general price movements.


With international price movement remaining constant, whether the external value of a national currency will change depends, among other things; on the responsiveness of the foreign demand for a nation’s total exports to a slight change in that nation’s export prices in terms of foreign currencies. Take, for example, the world demand for British exports, which is generally elastic with respect to price.

Suppose that the pound sterling becomes depreciated as a result of an appreciation of other currencies, thus making British exports cheaper in terms of foreign currencies and British imports more expensive in terms of sterling. Since the world demand for British exports is assumed to be elastic, there would be a shift of demand in world market in favour of British exports.

Since, also, the depreciation of the pound sterling has the effect of discouraging imports into Britain, the probable result would be a net increase in the world demand for pound sterling, or what is the same, in the British supply of foreign exchange. This increase in derived would demand for pound sterling exchange would result in an appreciation of sterling. Thus, a change in the external value of pound-sterling has been brought about without any international price changes.

As for the income-elasticity of demand for imports, the change in the demand for foreign goods and services and in the derived demand for foreign exchange is functionally related to the change in the national income.

The income elasticity of demand (E =dM/dY/(M/Y ) may be regarded as the responsiveness of a country’s demand for another country’s exports to changes in the domestic money incomes of the former country. In other words, it is the character of the propensity to import out of a given income that is supposed to affect exchange rates independently of international price movements.

A similar analysis applies when productivity increases as a result of some technological improvements in one country, for such a structural change expresses itself in an increased demand for that country’s cheaper and perhaps better exports. This is especially true of innovations in the export industry. Tariff changes and export subsidies would similarly influence exchange rates via their influence upon reciprocal demand quite independently of international price movements.

Capital Movements:


Capital movements are the other important influence that Keynes mentions. Although Keynes concentrates on short-term speculative capital movements long term capital movements may have an equally important affect on exchange rates.

It can be stated in general terms that an inflow of “hot money” or an import of “refugee capital” tends to raise the exchange value of the currency of the capital receiving country and that a withdrawal of such capital will lower it. Thus an actual or expected change in the domestic price of a foreign currency may lead to an inflow or outflow of “hot money” to cause a further change in the exchange rate between any two currencies involved, without there being any price changes in either country.

As for the influence of long-term capital movements, the exchange rate between the dollar and the pound sterling, for instance, will be affected by whether it is the United States or Britain that does the lending on long-run. The one-side a export of capital tends to raise the external value of the capital receiving, country’s currency, and that the one-sided import of capital tends to lower the external value of the capital-exporting country’s currency.

There are many other criticisms of the ppp theory, both theoretical and practical but the foregoing discussion of the basic defects of the parity theory suggested by Keynes, namely, the failures to consider the influence of reciprocal demand and to appreciate the independent role of capital movements, is sufficient to show that the determination of the external value of currencies depends not only on international price relations but on many other factors.

Residual Validity of PPP:

Most critics of PPP, after making their case against the theory do not reject it outright. They recognize what may be termed the “residual validity” of PPP, the theory’s range of applicability that remains even granted the criticisms that have been raised.

Haberler sees three situations in which the PPP theory has applicability:


(i) First, “under normal circumstances the theory holds in an approximate fashion in the sense that it would hardly be possible to find under such circumstances a case where an equilibrium rate is, say, 15-20 percent of purchasing power par”.

(ii) Second, when general price movements dominate changes in relative prices, relative PPP is a useful concept: “if cautiously used along with other evidence, PPP calculations have considerable diagnostic value, especially in periods of sever inflation”.

(iii) Finally, when trade relations between countries have been interrupted (owing to war, for example) or have been reduced to a barter or government-to-government basis, PPP can provide an indication of the equilibrium exchange rate that would apply when normal trade relationships are resumed.

Metzler writes: “In my opinion, the criticism of the parity doctrine, went to far and the theory was rejected even for situations in which it was valid”.

When large inflations have taken place in different countries, relative PPP provides an approximate measure of the new pattern of equilibrium exchange rates.

Ellsworth notes that in spite of the criticisms directed against it, PPP “continues to be widely used as a basis for estimating equilibrium exchange rates for purchasing power par alone are data available which will permit the calculation of a concrete rate. Therefore purchasing power par has almost irresistible attractions in spite of its pitfalls”.


He agrees with Metzler that PPP is legitimately applicable to situations in which general price movements are dominant. Other writers adopt a more restrictive scope for PPP, even while adopting I he- same line of argument. For example, Machlup accepts relative PPP as valid only when great changes in exchange rates are to be explained. He implies that general movement of prices must be so large: is to approach hyperinflation; for only then can one be certain dominate structural changes.

‘While changes in tastes, changes in productivity, changes in capital movements, etc. can change exchange rates somewhat (or even by substantial percentages), inflation in one of the countries can change the rates by huge multiples”.

Stern also would not apply PPP to periods of merely moderate inflation; for only under rapid inflation are changes in relative prices likely to be minimal. In the same vein Lutz notes that if “the purchasing power parity theory contains an important Kernel of truth”

The theory nevertheless applies only when disturbances in the balance of payments are due to monetary as distinct from real factors. On the other hand Kindleberger is in accord with Haberler in seeing a wider applicability of PPP, as least in the relative form. The computed parity provides an approximation to the new equilibrium exchange rate after an interruption of trade.

More generally “It helps to suggest what changes are necessary in the exchange rate (or in price level) when inflation is proceeding at different rates in different countries. The implication is that even if rates of inflation are only moderate, nevertheless they provide scope for the theory to operate. Finally, Harry Johnson observes that relative PPP” is a reasonable approximation for the analysis of short-run monetary disturbances of the type with which Cassel was concerned and provides a rough guide for policy makers obliged to decide the magnitude of exchange rate changes. As a matter of fact, the exchange rates of the major countries do not depart very far (typically less than 20 percent) from purchasing power parity”.


Apart from the development of the cost parity concept, there is nothing in the current state of PPP theory that was not embodied in Cassel’s writings. It is the principal virtue of the PPP approach that computation of equilibrium exchange rates can be performed “on the back of an envelope” without the need of sophisticated econometric or mathematical techniques. The PPP approach may also be of value in forecasting floating exchange rates. One requires only price indices for this purpose, and they may be forecast from existing econometric models.


The PPP doctrine claims that the foreign exchange rate is determined by the ratio between the real purchasing power of two currencies. The price levels of the two countries would thus be the Independent variables, the exchange rate the dependent variables of the relationship. So far, supply and demand conditions for foreign exchange have served to explain the determination of foreign exchange rates.

And again we saw without inflation or deflation in any in the countries concerned, the exchange rates between them would l)c changed through a number of events, namely, capital movements,” tariffs, improvement in technology or improvement in productivity; told movements and above all elasticities of reciprocal demand. But nothing is more capable of altering the supply and demand conditions and thus the exchange rate of a currency than inflation.

The explanation of very great changes in the exchange rates has to turn to the increase in the monetary circulation and the subsequent changes in the supply and demand conditions as the causal factors. Thus, there cannot be even a minutes doubt that the Balance of Payments. Theory foreign exchange was all wrong and the inflation theory otherwise known as the PPP doctrine is essentially correct when the vast movements in the foreign exchange markets was discussed in the l920’s with particular reference to the German inflation and depreciation of German mark.

In this historical perspective, the PPP theory must be given the full credit. But this must not blind us to the fact that changes in the foreign exchange market less conspicuous but significant enough may take place without any preceding change in the monetary circulations and purchasing power parities of the currencies concerned.