PURCHASING POWER PARITY (PPP)

PURCHASING POWER PARITY (PPP) :
- This refers to a theory of exchange rate based on relative domestic and foreign prices and used as a valuable tool for assessing proper currency valuation and measuring relative competitiveness.
- The basic proposition of PPP is that identical goods must sell at identical prices in a competitive market place.
- Otherwise, there will be opportunities for arbitrage.
- Competition will tend to equalise the price of identical basket of goods in domestic and foreign markets, through movements in exchange rate or though competitive bidding of the price abroad to the level of home prices.
- This measurement called absolute PPP does not often hold true because of quality differences, transportation costs, and other tariffs etc and therefore a relative version of PPP is suggested focussing on changes in prices and exchange rates.
- This version of PPP predicts that change in the nominal exchange rates will reflect differences in inflation rates among countries over time.
- Thus the countries in which inflation is persistently higher than that of the trading partners will experience a devaluation of their currencies.