Purchasing Power Parity

2. • PPP theory was propounded by the Swedish
renowned classical economist Gustav Cassel
in 1918
• Purchasing power of a currency is determined
by the amount of goods and services that can
be purchased with one unit of that currency
• One unit of home currency should have some
purchasing power in all countries

3. When a commodity can be sold in two different
markets, its price should be the same in both the
markets. It is called Law of One Price.
Conditions:
• There are no transportation costs
• There are no transaction costs
• There are no tariffs
• There are no restrictions on the movement of goods
• There is free flow of information
• There is no product differentiation

4. • Assume 1USD= 50 INR
• In the United States, cricket bats sell for $40, while in India
they sell for Rs.750
• 1USD = Rs. 50
• 40USD = ? = Rs.2000
• Since 1USD=50 INR, the bat which costs $40 in U.S. Costs only
$15 if we buy it in India.
• There is an advantage of buying the bat in India, so
consumers would be happier to buy the bat in India
• American consumers’ demand for Indian Rupees would
increase which will cause Indian Rupees to become more
expensive
• Thus prices in US and India would start moving towards
equilibrium

5. • Due to decrease in the demand for bats in the US,
its price drops to $30
• The increase in demand for the bats in India takes
price up to INR 1200
• At these levels, we can see that there is Purchase
Price Parity between both the currencies
• This means that whether we buy the bat in India or
in US, it is one and the same thing for the consumer

6. • Law of one price
• Inclusion of non-traded goods
• Price Index
• Stickiness of goods price
• Government interference
• Long term