Purchasing Power Parity.
Purchasing power parity theory states that the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at exchange rate are equivalent (Joseph, 2002).This means that ther price of goods like a computer in China and United States of America should costs the same taking into account the exchange rate between the two countries.
According to Sustav Cassel, a Swedish economist, the external value of currency depends on the economic purchasing power of that currency relative to that of another currency (Joseph, 2002).. This means rate of exchange between two inconvertible paper currencies is determined by the equality of their purchasing power or by their relative price levels. The purchasing power parity theory explains exchange rate determination and its currency fluctuations when different countries are on inconvertible currencies.
The theory of purchasing power parity is best explained using two principles the law of one price and from the Law of One Price (LoOP) to Purchasing Power Parity (PPP).
The Law of One Price (LoOP)
This law states that goods which are identical should be sold for same price in two separate markets when no transportation costs is incurred and no differential subsidies or taxes are applied in the two markets. In cases where no transportation cost is incurred on such goods, this opens an opportunity to make profit through trade. Therefore, discrepancies in price of goods is due to transport costs incurred between different countries and taxes applied by different countries and states on their goods thus leading to variation in prices of goods (Joseph, 2002)..
From Law of One Price (LoOP) to Purchasing Power Parity (PPP).
This theory of purchasing power parity is an aggregate of law of one price with a bit of twist added to it and it says that all identical goods should be sold between countries or in both markets. This law states that if two countries have different inflation rates, then the price of goods in both states will change. Hence, the price of goods is determined by exchange rate through the theory of purchasing power parity. In this case a country with a high inflation rate is believed to have its currency value decreasing.
In conclusion, the theory of purchasing power parity argues that the rate of exchange is usually determined by the ratio of purchasing powers between countries. Therefore, goods and services identical in nature from different countries should cost the same price in different countries. The price differential between different countries is not sustainable in the long run as the market forces (demand and supply) will tend to equalize prices between states or countries and their exchange rates.