Purchasing Power Parity Principle (PPP)

This theory was developed after the break down of the gold standard post World War I. Before the First World War, all the major countries of Europe were on the gold standard. The rate of exchange used to be governed by gold points. But after the First World War, all the countries abandoned the gold standard and adopted inconvertible paper currency standards in its place. The rate of foreign exchange tends to be stabilized at a point at which there is equality between the respective purchasing powers of the 2 countries. For Example; say America and England where the goods purchased for 500 $ in America is equal to 100 pounds in England. In such a situation, the purchasing power of 500 US $ is equal to that of 100 English pounds which is another way of saying that US $500 = 100, or US $5=1 pound.  The price level in countries remain unchanged but when foreign exchange rate moves to 1=$5.5, it means that the purchasing power of the pound sterling in terms of the American dollars has risen. People owing Pounds will convert them into dollars at this rate of exchange, purchase goods in America for 5$ which in England cost 1 pound sterling and earn half dollar more. This tendency on the part of British people so to convert their pound sterling into dollars will increase, the demand for dollar in England, while the supply of dollar in England will decrease because British exports to America will fall consequently the sterling price of dollar will increase until it reaches the purchasing power par, i.e. 1=US $5. If on the other hand, the prices doubled in both the countries, there would be no exchange in the purchasing power parity rate of foreign exchange, this, in brief is the purchasing power parity theory of foreign exchange rate determination. The change in the purchasing power of currency will be reflected in the exchange rate.