Purchasing Power Parity | Theories of Foreign Exchange Rate

1. There are 3 theories of the determination of foreign exchange rate.
2. Following are:
1. Mint Parity Theory 
2. Purchasing Power Parity 
3. Balance of Payment Theory 

The Purchasing Power Parity : 

1. The PPP theory was developed by Gustav Cassel in 1920. 
2. This theory determine the exchange rate between countries on inconvertible paper currencies. 
3. The theory states that Equilibrium Exchange Rate between Two Inconvertible paper currencies is determined by the Equality of the Relative Prices in the 2 countries. 
4. There are 2 versions of the PPP theory: 
1. The Absolute 
2. The Relative 

The Absolute Version Of PPP Theory:

1. The Absolute Version of PPP theory states that the Exchange Rate of between 2 currencies should be equal to the ratio of the price indexes in the 2 countries. (in Hindi: निरपेक्ष संस्करण बताता है कि दो मुद्राओं के बीच विनिमय दर दो देशों में मूल्य सूचकांक के अनुपात के बराबर होनी चाहिए।)
2. This version is not used as it ignores transportation costs and other factors which hinder trade, non-traded goods, capital flows and real purchasing power.

The Relative Version of PPP Theory:

1. It is an Economic Theory.
2. It predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their currencies over the same period. 
3. It is a dynamic version of the absolute purchasing power parity theory.
4.  An Example

• Suppose there are 2 countries i.e. India and USA.
• And both are on inconvertible paper standard.
• Now, in India, in order to buy a one burger takes Rs. 60. 
• And, in USA, in order to buy same one burger takes $1. 
• that means, According to PPP theory,the exchange rate will be Rs. 60 = $1.
• If the price-levels remains same in both countries but exchange rate moves to Rs. 50 = $1.
• This means less rupees are required to buy a burger in India as compared to $1 in USA. (It is a case of overvaluation of the Exchange Rate.)
• This will encourage imports and discourage exports.
• As a result, the demand for $ will increase and that of Rs. decreases. 

and, 

• On the other hand, if the exchange rate moves to Rs. 70 = $1.
• The Indian currency(₹) becomes Undervalued. 
• As a result, Exports are encouraged and imports are discouraged.
• The demand for rupees will rise and that for dollar fall. 
• So that the normal exchange rate of Rs. 60 = $1 will be restored.

To calculate Equilibrium Exchange Rate =