The Theory Of Purchasing Power Parity

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David Ricardo came up with the theory of Purchasing Power Parity (PPP). PPP is an economic technique used to estimate the level of adjustment needed to arrive at an agreed exchange rate between two currencies in order that trade can effectively take place. When the price of two commodities from two different countries is converted into one currency, the price of both commodities should be the same. One way of determining the inter-currency exchange rates is to carry out a PPP test. This test will also help to prevent commodity traders from buying cheaply and selling at significantly higher rates.
The basic measure of PPP is the law of one price: Pi=EiP*i, where Ei is the exchange rate, Pi = log (CPI of the domestic country), and P*i= log (CPI of the foreign country). The equation means that the good i should have same price when the exchange rate is applied to it. This is because there is an arbitrage in exporting goods from the country that has a low price to a country that has a high price. In the long term, prices “when converted into the same currency at market exchange rates”, should be equal “across economically integrated countries”. (Voinea: 2013, p.6)
There are two ways to measure PPP. The first one is Absolute PPP (APPP) which states that the exchange rate between two countries should be equal to the price of a basket of items in two countries due to arbitrage, i.e. ∑▒p_i=E∑▒p_i^* , where E is the exchange rate. The second measure is Relative PPP (RPPP)
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