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PPP theory holds that the exchange rate between two currencies is determined by the relative purchasing power reflected in the price levels expressed in domestic currencies in two countries concerned. Changes in the exchange rates are explained by relative changes in the purchasing power of the currencies caused by inflation in the respective countries concerned. The concept of PPP is originally traced to the British economist David Ricardo, but the credit for stating the theory in an orderly manner is given to Swedish economist Gustav Cassel who proposed it in 1918 as the basis for new set of exchange rates for resumption of normal trade relations at the end of the First World War. PPP theory is stated in two versions the Absolute Version and the Relative Version.

This is based on the law of one price. This law states that under conditions of free market with the absence of transportation cost, tariffs and other frictions to free trade, the price for identical goods should be the same at any market when measured in terms of common currency. Example; if a particular quality of coffee seeds costs Rs. 100 per Kg in India and the same commodity cost $ 2 in USA. The exchange rate between $ and Rs in the market will be Rs. 50. This means that when the $ price of coffee is converted into Rs. it will be the same Rs.100 prevailing in the domestic market. If the exchange rate in the market is anything other than Rs. 50, it will lead to arbitrage possibilities. The arbitrage operations will ultimately lead the exchange rate to the equilibrium level. Suppose the market rate for $ is Rs. 45. In the absence of transaction costs, traders in India will find that the coffee seeds in USA is priced low in terms of $ as compared to its rupee price. They will find it advantageous to buy coffee seeds in USA and sell in the domestic market.

Suppose a trader imports 1000 Kgs of coffee seeds. He will pay Rs. 90,000 to acquire $ 2000 from the market. He can sell 1000 Kgs of coffee seeds in the domestic market at Rs. 100 per Kg and earn a profit of Rs. 10,000. Similar operations will be done by other traders in India to take advantage of the situation. The combined effect of the operations of all the traders is that the demand for $ increases in the foreign exchange market, pushing its price in terms of rupees. The $ will continue to strengthen until the arbitrage profit is totally eliminated. That is the level where the price of coffee is same when measured in terms of either rupee or $. In the reverse situation, if the exchange rate per $ is Rs. 54, traders in India will find it advantageous to sell coffee seeds in USA to get a higher price realisation. The operations by all traders will lead to increase in the supply of $ in the market exerting downward pressure on its price in terms of rupee. The exchange rate will move to a level where arbitrage is no more possible.

Instead of a single commodity, we can imagine a basket comprising of a variety of products. If a basket of products costs Rs. 10,000 in India and the same set of products costs $ 200 in USA, the $ will be quoted at Rs. 50 in the foreign exchange market. The absolute version of PPP can be stated symbolically as : Pd e = ---------- where Pd = Price in domestic currency Pf Pf = Price in foreign currency e = exchange rate for the foreign currency in terms of domestic currency If the price in the domestic market rises relative to the price level in the foreign market, the domestic currency will depreciate proportionately against the foreign currency. In the above example, if the cost of basket increases to Rs.11,000 in India, while the price remains unchanged in USA, the $ will now be traded at Rs. 55 to maintain the price parity indicating depreciation of rupee or equivalent appreciation of $.

The absolute version of the PPP is based on the unrealistic assumption of free trade, no transportation costs, no taxes (or differentials) and identical commodities (no product differentiation). Transportation cost is a big hurdle in taking advantage of lower prices in another market as movement of goods and services is not free. Added to this, the commodities in a basket may not be identical and may differ in quality. Further, there are certain goods which do not enter international trade, for ex; housing. Given the above limitations, it is assumed that the exchange rate in the market may differ from the absolute PPP. Let us assume that when the basket of commodities is Rs. 10,000 in India and $ 200 in the USA, the market may quote Rs. 45 per $. What is expected is that the exchange rate will move along with the relative changes in the prices in the two countries. If the price of basket increases to Rs. 11,000 in India and it is now costing $212 in USA, the rupee will suffer a depreciation in relation to $
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The extent to which the rupee will depreciate is the difference in the inflation rates in the two countries during the period. In the above example, assuming that the inflation is 10% in India and 6% in USA, the rupee will depreciate approximately by 4% to quote at about Rs. 46.80. In order to maintain the PPP, the change in the exchange rate should be proportionate to the change in the relative purchasing power of the currencies concerned.
New exchange rate Proportionate change in domestic price --------------------------- = ----------------------------------------------------------Old exchange rate Proportionate change in foreign price 11,000 ------------ x100 New exchange rate 10,000 -------------------------- = --------------- = 46.70 45 212 -------x100 200
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Symbolically, this can be stated as :

et (1+ Id) --- = ----------e (1+ If)

OR

(1+Id) et = e ----------( 1 + If)

Where et = expected exchange rate after period t Id = rate of domestic inflation during period t If = rate of foreign inflation during period t
1.1 et = 45 ------- = Rs. 46.70 1.06

In practice, in the place of basket of products, price indices are used to compute the PPP. Suppose, the price index in India and USA are 100 and the exchange rate is Rs. 45 a dollar. At the end of the period, the price index in India is 115 and in USA it is 108. the exchange rate will move to Rs. 47.92.

et = ------45

115 -------100 --------- = Rs. 47.92 108 -------100