Purchasing power parity theory and its significance

Purchasing power evaluation theory is divided into two forms:

Absolute purchasing power parity (absolute purchasing power parity);

Relative purchasing power parity.

Absolute purchasing power parity holds that the value and demand of a country's currency are determined by the quantity of goods and services that a unit currency can buy at home, that is, by its purchasing power, so the exchange rate between the two currencies can be expressed as the ratio of purchasing power of the two currencies.

Relative purchasing power parity (PPP) takes inflation into account when expressing the change of exchange rate over a period of time.

19 18 after the end of the first world war, economists revised the absolute purchasing power parity because of the indiscriminate issuance of bank notes by countries during the war, inflation and rising prices. They believe that the exchange rate should reflect the relative changes in the price levels of the two countries, because inflation will reduce the purchasing power of currencies in different countries to varying degrees.

Purchasing power parity determines the long-term trend of exchange rate. Regardless of various short-term factors affecting exchange rate fluctuations in the short term, in the long run, the trend of exchange rate is basically consistent with purchasing power parity. Therefore, purchasing power parity provides a better method for forecasting long-term exchange rate trends.

Absolute purchasing power parity formula: R = PA/PB

R is the exchange rate calculated at absolute purchasing power parity;

PA and PB are the general price levels of A and B.

Relative purchasing power parity formula: R 1 = R0IA/IB.