Discuss the theory of purchasing power parity, by considering its Essay

Discuss the theory of purchasing power parity, by considering its various forms and examining critically its assumptions and the - Essay Example The rate of exchange between two currencies can be termed as equilibrium when there is an equivalence in the purchasing powers of these countries at the domestic level (Taylor & Taylor 2004, p. 135). The theory of Purchasing Power Parity The formula for calculating purchasing power parity is as follows: S=P1/P2, where S refers to the rate used to exchange currency one with currency two, P1 is the price that good â€Å"x† costs when purchased in currency 1, and P2 is the price at which good â€Å"x† sells when purchased in currency 1. Based on the Purchasing Power Parity, there is an adjustment in the exchange rate in order to ensure that similar goods in two countries can be bought at the same price when the same currency is used to express the value of the good. There tends to be various forms that the Purchasing Power Parity takes. Some of the most common forms that this theory takes include the absolute Purchasing Power Parity and the Relative Purchasing Power Parity (Apte et. al., 2001). The concept of Absolute Purchasing Power Parity holds that the rate of currency exchange between two countries remains the same as the price level ratio in these countries. The absolute PPP borrows from the law of one price. Based on one price law, the cost of a certain product should remain constant across several countries. The similarity in price should be  in accordance to the currency value in the economies of both countries. This should take consideration of all other prices, such as trade regulations and other factors affecting market demand and supply, which should remain the same between these countries. The absolute Purchasing Power Parity also holds that there the purchasing power of the foreign and the domestic policy should remain the same. This means that there should be no variation in price when a consumer wants to exchange a foreign currency for a domestic currency, or a domestic currency for a foreign currency (Almas 2012, p. 1093). In orde r to meet the premises for the absolute Purchasing Power Parity, several conditions have to be fulfilled. One condition that must be met is free trade of the goods from each country in the international market. The other condition is that there ought to be a compromise of the price index of the price index for each of the two countries, which will be involved in the exchange of goods. Absolute PPP can result from the differences that exist in weighing, regardless of the fact that the law of one price can hold for certain goods across nations. While determining the absolute purchasing power parity, there is a tendency to examine the changes taking place in the level of the prices, which can be calculated easily (Apte et. al., 2001). Relative purchasing power parity can also be regarded as another form that the theory of PPP takes. Relative PPP focuses on the changes in the inflation rates, which may be anticipated, in relation to changes in the exchange rates between countries. The r elative purchasing power parity explores the change and variations in prices that take place between two countries. Relative PPP posits that there tends to be a change in the exchange rates in order to ensure that the variations and differentials, which inflation causes, can be compensated for and covered (Almas 2012, p. 1097). In the relative purchasing power parity, the formula that explains the relationship is as follows: S1/S0= (1 +