What are the Criticisms of Purchasing Power Parity Theory of Rate of Exchange?

Even this “relative” version of the purchasing power parity theory has many weaknesses. Actual exchange rates are often different from calculated purchasing power parities and these deviations are often put forth as a ground for the rejection of the purchasing power parity theory. As such the theory has been criticised on various grounds:

1. The theory proposes a direct functional relation between the purchasing powers of the currencies of two countries and their exchange rate. However, in reality there is no such direct and precise link between the two. There are many factors apart from the purchasing power of currencies, such as tariff, speculation, capital flows, etc., which significantly affect the rate of exchange.

2. According to the theory, to calculate the new equilibrium rate one must know the base rate i.e., the old equilibrium rate. But it is difficult to ascertain the particular rate which actually prevailed between the currencies as the equilibrium rate.

3. Moreover, the calculated new rate would represent the equilibrium rate at purchasing power parity only if economic conditions have remained unchanged.

4. According to some critics, the purchasing power parity theory may hold good only in case of prices of goods entering into the foreign trade, but it is illogical to apply it in terms of general indices as there cannot be any direct relation between the internal and international prices of good just confined to only domestic markets of the trading countries. Keynes, therefore, remarks that” confined to internationally traded commodities, the purchasing power parity theory becomes an empty truism.”

5. The theory assumes that, we are regaling with a similar group of commodities in both countries. This assumption is not tenable, when the very base of international trade is geographical specialisation in production. Moreover, the concept of a change in the price is vague in theory.

Prices of all commodities never move uniformly. Prices of some commodities rise or fall much more than those of others. Under such conditions, no simple comparison can be made between the price movements in different countries.

6. A major criticism against the theory concerns the practical problem of calculating the exchange rate on the basis of the theory. The theory suggests the use of price indices for measuring the changes in purchasing power.

But there are several kinds of price indict s such as wholesale price index numbers, cost of living index numbers etc. So the question arises: which of these index numbers should be used for calculating the changes in purchasing power? Moreover, price indices in different eat countries are not comparable, as they are constructed on different bases and differ in respect of the base period, representative commodities included weights assigned to different items and the method of averaging. In short, a comparison of such index numbers of any two countries does not give us true purchasing power parity.

7. Another drawback of the theory is that it fails to take into consideration any items in the balance of payments other than merchandise trade. That is to say, the purchasing power parity theory applies at best only to current account transactions, neglecting capital account completely. Kindleberger states that, purchasing power parity theory is designed for trader nations and gives little guidance to a country which is both a trader and a banker.

8. The theory assumes that changes in price levels could bring about changes in exchange rates not vice versa, that is, changes in exchange rates cannot affect domestic price levels of the countries concerned.

This is not correct. Empirical evidence has shown that exchange rate governs price rather than the latter governing the former. Prof. Halm opines that the national price levels follow rather than precede the movements of exchange rates. He states: “A process of equalisation through arbitrage takes place so automatically that the national prices of commodities seem to follow rather than to determine the movements of the exchange rates.”

9. The theory applies to a stationary world. Changes in economic relations between two countries are ignored by the theory. It fails to take into account that the equilibrium exchange rate might also change following the changes in economic relations between two countries, although, price levels may remain unchanged. For instance, when some third country enters foreign trade as a competitor, the flow of trade between the original two countries will be affected, influencing the rate of exchange.

10. The theory assumes free trade and absence of exchange control for a steady exchange rate based on PPP. In reality, however, state intervention in the free flow of international trade such as export duties, import duties, import quotas or import licensing and exchange control devices cause a permanent deviation from the rate of exchange determined by relative price levels -the purchasing power parity. Temporary deviation from the purchasing power parity may also occur on account of the operations of speculators or due to movements of capital caused by panic.

11. According to Keynes, there are two basic defects of the parity theory, namely, (i) it fails to take into consideration the elasticities of reciprocal demand, and (ii) it fails to consider the influence of capital movements. In his view, foreign exchange rates are determined not only by price movements, but also by elasticities of reciprocal demands, and other supplies of foreign exchange

12. As Vanek states, the theory may serve as a crude approximation but does not offer] satisfactory explanation of the exchange rate determination. The theory as such also faces serious statistical difficulties – the difficulties associated with the computation of price indices. Particularly, the choice of weights (Qo) will greatly influence the value of R, if the ratio is not constant. The different sets of weights will be bound to produce discrepancies in the result.

Finally, the actual application of the purchasing power parity doctrine for calculating the exchange rate has proved that it cannot give a correct forecast of the equilibrium exchange rates. Thus, theory cannot be useful for calculating with precision the actual equilibrium exchange rates.

Purchasing power parity is nothing more than an expression of a long period tendency which assumes free working of economic forces. Halm thus concludes that: “Purchasing power parities cannot be use to compute equilibrium rates or to gauge with precision deviations from international payment equilibrium.” At best, purchasing power parities can be used for finding the approximate rang with which the equilibrium rate of exchange can be located.

Evaluation

In spite of all its limitations the purchasing power parity doctrine is the only sensible explanation of long-term changes in exchange rates under all monetary conditions, gold standard, etc. the theory also explains what determines the balance of payments itself. It shows that trade and payment between countries change mainly due to changes in relative price levels of the countries concerned In the long run, therefore, the exchange rates depend on relative prices and price changes.

The theory has its importance when price movements are a significant factor affecting exchange rates. But when price fluctuations are not so important, the theory has little significance.

In fine, although, the theory has its shortcomings, it explains the working of a long-term tendency in exchange rates, which has an important bearing on practical policy in regard to foreign trade and payments.