Free essays

A theory that proves that there is equilibrium between the exchange courses of one currency with another one, when their home purchasing powers are equivalent, is named PPP theory (theory of purchasing power parity). It means that the cost of good should be the same, for example, in the USA and in Canada when one takes into consideration the course rate.

David Ricardo was the first who referenced on this theory, but it was popularized in 1918 by Gustav Cassel. Foreign currency always had some purchasing power. What concerns the domestic currency it has also its own purchasing power but only in the domestic economy.

It means that when one exchanges domestic currency for any foreign currency, the domestic purchasing power is exchanged for the purchasing possibility of foreign currency. According to the purchasing power parity, the exchange courses of both currencies should show the relation between the foreign purchasing powers of the different currencies.

Theory of purchasing power parity tries to establish relationship between the exchange rates and domestic price level. It explains the nature of trade and defines balance of payments of a nation.

However, one cannot name this theory the ideal one, as it provokes much critic opinions. Some critics suppose that theory of purchasing power parity limits the price index. Purchasing power parity theory uses the price index to measure the changes in the rate of exchange. It has been proved that price indices can vary according to various limitations.

One can distinguish two types of purchasing power parity:

1)  absolute purchasing power parity, which is based on equal prices in countries;

2)  relative purchasing power parity, which reveals the inflation rate.

It is also necessary to say that the theory of purchasing power parity is equilibrium between the exchange courses of one currency with another one, when their home purchasing powers are equivalent. This theory provokes the positive and negative opinions. It was proved that this theory is theoretical one rather than practical. One can not put this theory in practice completely, as it is too idealistic.

Live ChatLive Chat

The Importance of Purchasing Power Parity Theory

Economists believe that purchasing power parity theory is connected with the international relations, as one deals with the domestic and foreign currencies. Purchasing power parity is used in order to describe incompatibility between economic dimensions of the different countries. When considering the importance of purchasing power parity, it is necessary to admit it influences on economic decision-making, though it still provokes criticism and controversies.

With the help of PPP theory one can account the differences in inflation levels and changes of prices in different countries. Purchasing power means the amount of goods that one person can buy with a certain sum of money in his/her country. As for the purchasing power parity, it defines the level of prices and possibility of people of one country to buy the same goods comparing to those of the people of another country.

The principle of purchasing power parity has the name that the law of one price. This law states that the same goods should have the same price at the global market. Purchasing power parity theory is connected with the process of globalization. Globalization is the process that eliminates economical, political, and cultural barriers between countries.

Historically, the establishment of agreements and treaties between nations is the oldest way of international relations. The status of any country in the world should be one of the directions of its politics. It is the globalization that can help them to occupy their places on the international scene. Moreover, globalization is the step forward, as it advances the position of the country. Purchasing power parity theory is the connection between countries when the case concerns their international relation, regulation of currencies, and prices.

Purchasing power parity theory is important for economy. It can develop reasonably accurate economic statistics and compare the market conditions of different countries. Purchasing power parity is used for the calculations of gross domestic product. However, purchasing power parity is not the same in all countries, and it can vary from country to country. The statistic of gross domestic product is based on the theory of purchasing power parity.

Collaboration of countries in purchasing power parity benefits positive international relations. Positive international relations provide effective collaboration in trade policies between nations and positively influence import and export.

International relations play no less important role in border control policies and, without doubt, in economic policy. Economic policy is the basement for the relations between any countries. On international scene, every country should be an assertive player in international discussions on economy, politics, peace, security, culture, and development.

It is known that purchasing power varies constantly; that is why, one deals with such processes as overvaluation or undervaluation of a nation's currency.

Our discountsOur discounts

One can distinguish five key dimensions of the theory of purchasing power parity:

1) The theory of purchasing power parity defines the rates of domestic and foreign currencies and prices. It shows influence and power of economic mechanisms. It is impossible to make political policy without foreign economic relations. Only politics, economy and foreign relations in complex can create global economy. That is why, the basement of the theory of purchasing power parity is the international economic relations.

2) The theory of purchasing power parity can develop reasonably accurate economic statistics. As one may see, this theory has more theoretical character.

3)Purchasing power parity theory is used for calculations of gross domestic product, which defines the level of economics.

4) Purchasing power parity compares the market conditions of different countries.

5) Purchasing power parity theory is the connection between countries in the questions of international relation, regulation of currencies, and prices.

The Disadvantages of Purchasing Power Parity Theory

At present time, it is possible to state that the notion of purchasing power parity is somewhat overestimated. Though the logics of the theory is quite simple to follow, it is evident that the basis of it lacks empirical support. Thus, one may state that in connection to this reason, the theory is of no value to economic calculations.

Purchasing power parity theory has the theoretical character. It is impossible to put it in practice completely. It indicates the direct connection between purchasing power of the exchange rates of currencies of two countries; however, there is no such a direct relation between two different currencies.

Other critics suppose that theory of PPP neglects demands and supplies. This theory can not explain the demands and supply of foreign exchange. The exchange course is defined not only by price level and price indices but also by demands and supply of international currency.

Theory of PPP is characterized by the unrealistic approach. It uses price indices that are unreal, and that is why the quality of services and goods which are included in the indices are different from nation to nation. The theory of purchasing power parity is based on unrealistic assumptions that there are no barriers that prevent the international trade.

Theory of PPP neglects the impact of foreign capital movements on the foreign exchange market. There are many discussions whether purchasing power parity theory is practical or not; that is why, this theory provokes so many critical opinions.

Talk to an operator NOW!Talk to an operator NOW!

Conclusion

In conclusion, it is necessary to say that the theory of purchasing power parity is equilibrium between the exchange courses of one currency with another one, when their home purchasing powers are equivalent. This theory provokes the positive and negative opinions. It was proved that this theory is theoretical one rather than practical.

The theory of purchasing power parity defines the rates of domestic and foreign currencies and prices. It shows influence and power of economic mechanisms. However, only politics, economy, and foreign relations in complex can create global economy. That is why the basement of the theory of purchasing power parity is the international economic relations.

The theory of purchasing power parity can develop reasonably accurate economic statistics. As one can see, this theory has more theoretical character. Purchasing power parity theory is used for calculations of gross domestic product, which defines the level of economics. Purchasing power parity compares the market conditions of different countries. Purchasing power parity theory is the connection between countries concerning their international relation, regulation of currencies, and prices.

One can distinguish two types of purchasing power parity: absolute purchasing power parity, which is based on equal prices in countries, and relative purchasing power parity, which reveals the inflation rate. With the help of PPP theory one can account the differences in inflation levels and changes of prices in the different countries. Purchasing power means the amount of goods that one person can buy with a certain sum of money in his/her country. As for the purchasing power parity, it defines the level of prices and possibility of people of one country to buy the same goods as comparing to those of the people of another country.

Order Now

Globalization - a Rapid Process Economics Assignment
Related essays
LIVE CHAT
ORDER NOW
TO TOP