With the breakdown of the gold standard during the period of World War I (1914-18). Parities and free movements of gold ceased. The mint par of exchange, therefore, lost signifies in the exchange markets. Exchange rates fluctuated far beyond the traditional gold points and the was complete confusion. Hence, to explain this phenomenon and the problem of determination the equilibrium rate of exchange between inconvertible paper currencies the theory of Purchase Power Parity was enunciated.

Though, the original version of the theory can be found in John Wheatley’s “Remarks Currency and Commerce” (1802) and in Recardo’s writings too, it was developed and popular in 1918, by the Swedish economist Gustav Cassel who used the term “Purchasing Power Parity” explain the working of the theory. Cassel suggested Purchasing Power Parity as the appropriate level at which to set the exchange rate.

The basic idea underlying the purchasing power parity theory is that foreign exchange foreign money) is demanded by the nationals of a country because it has the power to command goods (purchasing power) in its own country (the foreign country). When the domestic currency of a nation is exchanged for foreign currency, what in fact is done is that domestic purchasing power is exchanged for foreign purchasing power.

It follows that, the main factor determining the exchange rate is the relative purchasing power of the two currencies, for, when two currencies are exchanged what are exchanged, in fact, are the international purchasing powers of the two currencies.

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Thus the equilibrium rate of exchange should be such that the exchange of currencies would involve the exchange of equal amounts of purchasing power. Hence, it is the parity (equality) of the purchasing powers of the currencies which determines the exchange rate.

Thus, the theory states that, of exchange tends to rest at the point at which there is equality between the respective purchasing powers of the currencies. In other words, the rate of exchange between two inconvertible
currencies tends to approximate the ratio of their purchasing powers. Hence, the theory seeks to explain that under the system of autonomous paper standards the external value of a currency depends ultimately and essentially on the domestic purchasing power of that currency relative to that of another currency.

The theory, however, has been presented in two versions: the absolute version and the relative version.