What Are The Limitations Of The Purchasing Power Parity?

Question

What Are The Limitations Of The Purchasing Power Parity?

2 Answers

Answer Question

Answer 1

There are many limitations when we talk about the purchasing power parity. First of all the rate of change is not determined by the relative price levels alone. The purchasing power theory envisages direct relationship between the purchasing powers of the currency units and the rate of exchange. The fact is that the rate of exchange is influenced by any other factors such as tariff speculation, capital movements. The theory does not take into consideration these other factors. The theory bases analysis on domestic price only. It does not consider the prices of the commodities in the international market. The price level is made up of internally traded plus internationally traded goods. As the theory confines itself to internationally traded goods the theory does not hold goods in practice.

There is another factor which is the effect of changes in foreign exchange rate ignored. The theory asserts that changes in price level induce changes in the foreign exchange rate. The fact however is that changes in the foreign exchange rates also influence price levels in many cases. The theory does not take this fact into consideration. This theory takes into consideration the merchandise trade accounts in the balance of payments. It ignores may items like shipping, insurances, banking transactions, income on investments, long term capital movements which also influence the exchange rate.

Answer 2

1. Ignores / Trade Restrictions: This theory ignores restrictions on foreign trade. This theory explains that the rate of exchange depends only upon the relative prices levels in the countries concerned. But is can be influenced by the trade restrictions also. For example, if a country imposes ban or import duties on the import of a large number of items then the exchange value of currency will rise even though its internal price level remains constant.
2. Ignores Non Trade Items: This theory throws light on trade items only that is goods and services and ignores non trade items such as unrequited transfers and capital movements so this is one sided theory.

3. Ignores Price Controls: Purchasing power parity theory could be true only when prices of the commodities are determined by the forces of demand and supply but different govt. adopt different price control methods in their own countries, therefore, the prices of the commodities are not the same in all the countries.
4. Ignores Speculative, Political Factors: The rate of exchange is also affected by speculative, political conditions and psychological factors. But this theory ignores these factors.
5. Ignores Dynamic Factors: This theory applies to a static world. Now-a-days the world is not static but dynamic. Technological advancement changes in sources of supply and the like factors may affect demand, supply and the rate of exchange even when relative prices remain unchanged.