Introduction to Purchasing Power Parity Theory:
According to this theory, rates of exchange between two countries are determined by relative price level.
The actual rate of exchange must be such that the same amount of purchasing power, when exchanged at that rate, must buy the same amount of goods and services in both the countries.
For Example, if by spending Rs. 60/- we can buy an amount of goods in India as we can buy with £1 in England the rate of exchange between England and India will be Rs. 60/- to £1. This is easily seen if we reflect on the fact that the price paid in a foreign currency is ultimately a price for foreign commodities, a price which must stand in a certain relation to the prices of commodities on the home market. Thus, we arrive at the conclusion that the rate of exchange between two currencies must stand essentially on the quotient of the internal purchasing powers of these currencies.
“The rate of exchange determined in relation to price-levels is known the Purchasing Power Parity”. This is a norm round which actual rates of exchange will vary. So long as the relationship between two price-levels remains unchanged, the rates of exchange will tend towards the parity. But it should be noted that this parity is not a fixed par like gold points. It is a moving par-changing with changes in price-levels.
How Purchasing Power Parity Theory is Determined?
It should be noted that the purchasing power parity theory is determined by comparing general price-levels and not the price-levels of internationally traded goods. Prices of exports and imports must remain at the same level in every country (barring of course, cost of transport) tariffs etc. Moreover, they are often the result of changes in exchange rates. Hence, it is easy to verify the theory by comparing wholesale standards.
The prestige and the so-called verifications of the theory from a comparison of the existing wholesale index numbers were due to the fact that the latter were overloaded with internationally traded goods. But parties should be “measured only by general index figures representing so far as possible the whole mass of commodities marketed in the country.”
The theory is an explanation of monetary adjustment and states that if the essential condition of international trade remains unchanged, foreign exchange rates will reflect those price-changes. But the conditions of international trade never remain the same. In particular, the barter terms of trade are constantly changing owing to changes in the demand for foreign goods, changes in the conditions of supply of exported goods, changes in the volume of foreign loans, changes in the costs of transport and in every item in the invisible balance of trade.
Further, we should take the case of a country which borrows from another. The increased supply of the foreign currency in the first country’s foreign exchange market will raise the value of the own currency in terms of the currency of the lending country. This change in the exchange rates will not always be reflected in suitable changes in the price-levels of the two countries.
If the barter terms of the trade change, the relationships between the price-levels of the different countries will change, and parties determined by comparing the former price-level relationship will fail to reflect changes in exchange-rates. The theory may thus be true only under circumstances when the terms of trade do not change.
Fluctuations of the Rates of Exchange and its Causes:
The Rates of Exchange fluctuate above and below the mint par. What are the causes which influence the movements of the rates of exchange? They may be grouped under two main heads: the demand and supply of foreign currency, and the currency conditions. The demand and supply of foreign currency arises from three sources.
(1) Trade conditions,
(2) Stock Exchange influences, and
(3) Banking influences.
1. Trade Conditions:
The demand and supply of foreign currency are dependent primarily on the volume of exports and imports. When exports are greater than imports, foreigners owe to us a greater sum than we owe to them. The rate of exchange moves in our favour. On the other-hand when imports are greater than exports, the demand for foreign currency is greater than the supply and the rate will fall. Among exports and imports we must include not only goods but the invisible items, because these also give rise to the demand for and the supply of foreign currency.
2. Stock Exchange Influences:
Stock exchange influences include the payment of loans, interest and re-payment of loans, the purchase of sale of foreign securities by home investors or of home securities by foreign investors. When a country gives loans to another the loans have to be transferred into the foreign currency. Its demand for foreign currency increases, and the rate of the exchange moves against it.
In the same way when home investors buy foreign securities or home securities are sold by foreigners the rate falls. But when loans are being repaid or when foreigners buy domestic securities, the demand for home currency or their part rises and the rate of exchange rises.
3. Banking Influences:
Banking influences include the purchase and sale of banker’s drafts, traveller’s letters of credit, arbitrage Operations etc. when a bank issues a draft or a letter of credit etc. on a foreign branch, the demand for foreign currency rises and the rate of exchange falls. Bank Rate is also an important influence on the rates of exchange.
When it is high i.e., in relation to other countries, foreigners will send funds to that country to earn the high rate of interest. The demand for home currency rises and the rate of exchange moves up. The opposite will happen when the bank rate is lowered.
The second group of factors which influence the Exchange Rate is:
(a) Currency Conditions:
The conditions of currency in a country also exercise important influence on the rates of exchange. If there is a rumor that the currency will depreciate due to an over issue of paper money, the demand for that currency will fall off, since no-body wants to transfer his funds into a currency whose purchasing power is likely to depreciate the rate of exchange will, therefore, rise and may jump up to abnormally high figures if there is a “flight from the foreign currency” i.e., if foreigners not liking to invest their funds to their home currency, hasten to transfer them to foreign countries where purchasing power is more stable.
Similarly, when the currency of one country is based on silver and another on gold, the rates of exchange will depend on the gold price of silver.
Besides these there are:
(a) The political conditions,
(b) The growth of speculative sentiment etc. which will affect the rate.
Limits to Fluctuations in Exchange Rates:
When both the countries are on gold standard the actual rates of exchange will fluctuate around the mint par of exchange within limits fixed by the gold points. The mint par is determined with reference to the value of the amount of pure gold in the coins of each country. The rate of exchange is said to be at par when it is the same as the mint par. The rate of exchange will fluctuate above and below the mint par. The limits to the fluctuations in the rates of exchange are fixed under gold standard by the gold or specie points.
The actual gold export point is determined by adding the shipping expenses etc. to the mint par. Similarly, the gold import point is found by subtracting the shipping expenses from the par. So long as the price of bills is within the gold points, merchants will buy bills in order to make payments to foreign countries. But if the price of bills is higher than the gold export point, they will send gold instead of sending bills.
Similarly, when the rate of exchange touches the import point, gold will be imported. Unlike the mint par which is stable so long as the gold contents and the fineness of the coins are not changed, gold points are variable according as the cost of freight, insurance etc. increase or decrease.
Favourable and Unfavorable Rates:
A country is said to have favourable exchange when the rate of exchange is near the gold import point; it has unfavorable exchange where the rate is near gold export point. When we have imported more and exported less we shall have to pay the foreigners for the imports by sending gold or other funds. The exchange is said to be unfavorable. Conversely, when our exports are greater than our imports foreigners must pay us by sending gold. The exchange is then said to be favourable.
Limits under Paper Currency Standard:
When both the countries are on inconvertible paper currency there are no gold points. The mint par is replaced by the purchasing power, Parity, determined with reference to the price-levels of the two countries. Unlike the mint par the purchasing power parity is a moving par, changing in response to every change in the prices. Though there is a part of exchange, there is however, no limit to the fluctuations in the rates of exchange. The latter will fluctuate in accordance with every change in the demand and supply of foreign currency.