The absolute version of the Purchasing Power Parity theory stresses that the exchange rates should normally reflect the relation between the internal purchasing powers of the various national currency units.
That is to say, the exchange rate should equal the ratio of the outlay required to purchase a particular set of goods at home as compared with what it would buy abroad. To illustrate the point, let us assume that a representative collection of goods cots Rs. 500 in India and $ 100 in the U.S.A. If the current rate of exchange is Rs. 5 = $1, the given quantities of representative articles will cost the same in either country, and the exchange is at the purchasing power parity. Thus:
Where Ip stands for internal purchasing power, which is the reciprocal of the index of general price level.
The right hand side of the equation shows the foreign exchange rate, where B is regarded as the foreign money. In statistical terms thus, the rate of exchange R may be expressed as:
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Where, R stands for the price of country A’s currency in terms of country 5’s currency. Pa stands for the prices in country A and Pb for the prices in country B. Qo stands for the corresponding weights. Here, P, the prices, relate to a representative bundle of items with assigned weights being the same for the two countries.
Thus, the foreign exchange rate is determined by the ratio of the internal purchasing power of the foreign money and the internal purchasing power of the domestic money. The ratio of the internal purchasing powers of the two currencies is called the purchasing power parity. Thus, in its absolute form, the theory maintains that, the rate of exchange will be in equilibrium when the purchasing power of money is equal in all the trading countries.
The absolute doctrine of the purchasing power parity is based on the assumption that prices of goods should be equalised by trade everywhere in the world. Where goods cost more in country A than in B, when A’s prices are converted into B’s currency at the existing exchange rater’s currency is overvalued by the percentage of higher cost.
Criticism
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Firstly, though, the absolute version appears to be very elegant and simple it is totally useless because it measures the absolute levels of internal prices. And we know that the value (or purchasing power) of money cannot be measured in absolute terms.
Secondly, the goods produced and demanded in two different countries are not of the same kind and quality. Therefore, the equalisation of goods prices – internal purchasing power of two currencies – cannot be easily envisaged.
As a matter of fact, the relative price structure between two countries cannot be identical on account of differences in qualities and characteristics of goods and services, differences in demand patterns, differences in technology, influence of transport costs, differing tariff policies, difference in tax structure, market imperfections of different degrees, different degrees of government intervention and control, and such other complex forces.