Page 181 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 15 : Theories of Determination of Exchange Rate (PPP, Monetary)

Notes

According to Cassel, the purchasing power parity is “determined by the quotients
of the purchasing powers of the different currencies.”

Its Criticisms. Cassell’s PPP theory became very popular among economists during 1914-24 and was
widely accepted as a realistic explanation of the determination of foreign exchange rate under
inconvertible paper currencies. But it has been severely criticised for its weak theoretical base. Some
of the criticisms are discussed as under :
1. One of the serious defects of the theory is that of calculating the price levels in the two countries.
The use of index number in calculations presents many difficulties such as the base year, coverage
and method of calculation. These may not be the same in both countries. The two countries may
not include the same types of commodities in calculating the index numbers. Such difficulties
make the index numbers only a rough guide for measuring the price levels and thus fail to give
the correct purchasing power parity between the two countries.
2. According to the theory, the purchasing power parity between two countries is determined by
comparing their general price levels. But the price level may be made up of internally traded
plus internationally traded goods, or of the internationally traded goods. If the price level is
calculated in terms of the internally traded goods, then the prices tend to equality in both
countries, even allowing for the cost of transportation, tariffs, etc. Thus, according to Keynes,
“confined to internationally traded commodities, the purchasing power parity becomes an empty
truism.” On the other hand, if the price level includes both internally and internationally traded
goods, then price of internally traded goods may move in the opposite direction of internationally
traded goods, at least in the short period. Thus the real exchange rate may not conform to the
parities.
Further, if the price level includes both types of goods, there is technical difficulty of people
spending their money differently in the two countries, so that the basis for complete and accurate
comparisons of price levels is lacking.
3. Another weakness of the purchasing power parity theory is that it applies to countries whose
balance of payments is determined by the merchandise trade account. It is, therefore, not
applicable to such countries whose exchange rate is influenced more by capital account.
4. The theory assumes the balance of payments to be in equilibrium in the base period for the
determination of the new equilibrium exchange rate. This is a serious defect, because it is difficult
to find the base year when the exchange rate was initially in equilibrium.
5. The theory is also based on the assumption that there have been no structural changes in the
factors underlying the equilibrium in the base period. Such factors are changes in technology,
resources, tastes, etc. This assumption is highly unrealistic because changes are bound to take
place in these factors which, in turn, are likely to affect exchange rate.
6. The theory is based on the assumption of zero-capital movements. There are many items in the
balance of payments such as insurance, shipping, and banking transactions, capital movements,
etc. which are not affected by changes in the general price level. But these items affect the
exchange rate by influencing the demand for and supply of foreign currencies. The theory is
thus weak for it neglects the influence of these factors in determining the exchange rate.
7. The theory further assumes that changes in the price level bring about changes in exchange
rates. But changes in exchange rates do affect the price level. For instance, if the external value
of rupee falls, imports will become dearer. As a result, the costs and prices of goods using
imported materials will rise. On the other hand, exports will become cheaper with fall in the
external value of the rupee. Consequently, their demand will increase which will raise the
demand for factors used for producing exports, and their prices will also rise. Thus changes in
exchange rate do influence the price level.
8. Again, the theory assumes that the barter terms of trade do not change between the two trading

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