Purchasing Power Parity (PPP):
The exchange rate is determined by the relative purchasing power of currency withineach country. For example, if a product X costs Rs. 100 in India and costs $2 in USA,then the rupee - dollar exchange rate is Rs. 50 per $. This illustrates the theory ofPurchasing Power Parity (PPP) wherein two currencies are at purchasing power paritywhen a unit of domestic currency can buy the same basket of goods at home or abroad.There are two versions of PPP, the Absolute PPP and the Relative PPP. The AbsolutePPP postulates that the equilibrium exchange rate between two currencies is equal tothe ratio of price levels in the two countries. Specifically,
R = P1/P2
Where P1 is the price level in the home country and P2 is the price level in the foreigncountry.The Relative PPP postulates that the change in exchange rate is equal to the differencein changes in the price levels in the two countries. Specifically
R' = p1'- p2'
Thus, the percentage change in exchange rate (R´) will be equal to the percentagechange in domestic prices (P´1) minus the percentage change in foreign prices (P´2).
This would be true as long as there are no changes in transportation costs, obstructionto trade (tariff and non-tariff barriers) and the ratio of traded to non-traded goods.Since trade and commodity arbitrage respond sluggishly (due to the above factors),relative PPP can be approximated in the long run.Thus, in the long run, the real exchange rate will return to its average level. In otherwords, if real exchange rate is above long run average level, PPP implies that theexchange rate will fall.