The purchasing power parity theory:
This theory is an application to the law of one price.
This theory states that exchange rate between any 2 countries will adjust to reflect changes in the price level of the two countries. This means that there is a predictable relationship between price level of the products and exchange rate. This relationship depends on the fact that people buy goods from each other according to the price they must pay.
Exchange rate changes, in the long run, should be proportional to a relative change in price level in the two countries.
Exchange rate = domestic price level / foreign price level
Ex:
If the price level in one country rises relative to another country price level, the currency of the first country depreciate while the currency of the second appreciate
Criticism of PPP theory
PPP theory can not fully explain changes in the exchange rate because of the following:
A- Good that produced in different countries are not identical so their prices will not be the same.
B- Considering the changes in price of non-traded goods as part of the price level leads to make exchange rate misleading.
C- PPP theory and law of one price ignores the transportation expenses which have effect on price of traded goods.
D- PPP theory and law of one price considered only the irrelative price level as the only determine of exchange rate changes on the long run and ignored other factors as:
- Tariff and quotes
The countries which use tariff and quotas to restrict its imports, its currency appreciate relative to the foreign currency because both of them raises, the foreign price relative to domestic price and hence the demand for foreign goods decreases relative to the demand for domestic goods and so the domestic currency appreciate while the foreign currency depreciate.
- Preferences for domestic goods relative to foreign goods:
If people in one country preferred domestic goods relative to foreign goods , domestic currency appreciates while foreign currency depreciates because the demand for domestic good increases relative to foreign goods.
- Relative productivity
If one country's productivity increases relative to another's, the currency of the first country relative to foreign currency.
+ The ability of PPP theory to predict exchange rate changes:
- at the level of one heavily traded goods, PPP theory predicts the changes in exchange rate very well both in the long run and short run such as gold, oil, and agricultural products.
- At the level of all traded goods, PPP predicts only moderately well either in short run or long run.
- At the level of all goods in the economy, PPP predicts changes in the exchange rate least well.
-in general PPP theory predicts exchange rate changes more better in the long run than in short run.
- although the defects of PPP theory, it implies that countries with low relative inflation rates, their currencies appreciate in the foreign exchange markets, while countries with high relatively inflation rates their currencies depreciate in the foreign exchange markets.