Slide 1

Purchasing Power Parity (PPP) The purchasing power parity theory establishes the idea that the ratio of price level and exchange rate between two countries must be equivalent. PPP means that the same goods or basket of goods should sell at the same price in different countries when measured in a common currency , in absence of transactions costs.Two Versions of PPP TheoryAbsolute or Positive Version: According to the absolute version of Purchasing Power Parity (PPP) theory, the exchange rate between two currencies should reflect the relation between the international purchasing power of various currencies. For example, suppose particular basket of goods cost 1,000in India and $100 in U.S.A. That means the exchange rate would be 10=$1. 2) Relative or Comparative Version: The relative version was put forward by Cassel in order to find the strength of the changes in the equilibrium exchange rate. Any departure from the equilibrium will lead to the disequilibrium. It can take place due to change in the internal purchasing power of a particular currency.