Purchasing Power Parity Theory. The determination of rate under paper currency standard is endeavoured to be explained by the purchasing power parity theory. This theory holds that the rate of exchange between two currencies depends upon their relative purchasing power in the countries concerned. For example, if one bag of sugar costs Rs. 500 in India and US $ 50 in the USA, the rate of exchange between these currencies is:
$ 50 = Rs. 500
Or, $ 1 = Rs. 10
Thus, the rate of exchange depends upon the purchasing power of Indian rupee in India and the purchasing power of US dollar in the USA. If there is a change in the price level in either of the countries, it will affect the exchange rate. If the prices increase in one country, it means the purchasing power has gone down in respect of the currency concerned and it will become cheaper in relation to the other currency. If prices fall, the purchasing power of the currency increases and hence the exchange rate also moves upwards in favour of the currency.
For example, if the price of sugar in India increases to Rs. 550 per bag and remains constant in the USA, the revised rate of exchange will be:
$ 50 = Rs.550
Or $ 1 = Rs. 11.
In the foregoing paragraph, the rate of exchange was determined based on a single commodity traded in both the countries. But international trade is not confined to a single commodity and hence an extended version of the theory bases the rate of exchange determination on the general price level in the countries concerned. For this purpose, the price indices are taken into account instead of the price of one commodity.
For example, let us suppose that the price index in India and the USA for a particular year was 100 and the rate of exchange was $1 = Rs. 8. Subsequently, the price index number in India increases to 150 points. This means the purchasing power of the rupee has reduced to this extent. Therefore, new rate of exchange between rupee and dollar will be:
$ 1 = Rs. 8 x (150/100)=Rs. 12
If there is a simultaneous increase in the price in India as well as the USA and the price index in the USA has moved up to 200 points, the combined effect of increase in price index in both the countries will be felt in the rate of exchange as under:
$ 1 = Rs. 8 x (150/100)x(100/200)=Rs. 6
Unlike the mint parity theory where the rate of exchange tends to be stable, the purchasing power parity theory has provided the reasons for fluctuations in the rate of exchange. But it is valid only when the commodities compared are similar. This is seldom possible. If price index is used, then the problem of choosing the correct base year and inclusion of identical items in the index pose further difficulty.
The theory asserts that the rate of exchange is determined by the purchasing power of the currency. But the rate of exchange is influenced by many factors like exchange control. Therefore, it can be concluded that the purchasing power parity theory does not present full explanation on the determination of exchange rates.