Purchasing Power Parity is a technique which is used to determine the relative value of different currencies. This whole concept of purchasing power parity allows people to estimate what will be the exchange rate between two countries so that the purchasing power of the two countries remains at par.
Purchasing power parity exchange rates are helped in minimizing the misleading international comparisons, which can arise due to market exchange rates. The idea of this concept germinated in the 16th century in the School of Salamanca and the concept in its modern form was developed in 1918 by Gustav Cassel. This entire concept of PPP is based on ‘the low of one price.’ This law translates to mean that when official trade barriers and transaction costs are absent, then the prices of identical goods will be same in all the different markets if expressed in one same currency.
When there are deviations in the parity which means that there are differences in the purchasing power in the ‘basket of goods’ of various countries, it become really important that the GDPs and other national income statistics will have to be ‘PPP-adjusted’ so that they are converted into common units, and the comparisons on the international level become easy to measure. The most common and popular purchasing power adjustment is Geary-Khamis Dollar, also known as the international dollar.
PPP exchange rate basically serves two main functions. They are:
• Firstly, purchasing power parity exchange rates are used to make comparisons between different countries, as they remain quite constant day-to-day and week-to-week, and only modest changes occur and that too, over years.
• Secondly, over the years the exchange rate between countries tend to move in the direction of the basic PPP exchange rate, and therefore it will be valuable to know as to in which direction the exchange rate is going to change in the long run.
Thus, it can be said that PPP theory generally states that the exchange rate between the currencies of two countries will be in equilibrium especially when the domestic purchasing power measured at that rate of exchange are equal.
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