Derivation of Purchasing Power Parity Purchasing power of a currency is determined by the amount of goods and services that can

be purchased with one unit of that currency. If there is more than one currency, it is fair and equitable that the exchange rate between these currencies provides the same purchasing power for each currency. This is referred to as Purchasing power parity. It is ideal if the existing exchange rate is in tune with this cardinal principle of purchasing power parity. On the contrary, if the existing exchange rate is such that purchasing power parity does not exist in economic terms it is a situation of disequilibrium. It is expected that the exchange rate between the two currencies conforms eventually to purchasing power parity. So, according to PPP the exchange rate between the two currencies should be equal to the ratio of these countries price level. For example, for US and India, the price index of a basket of products in US is P$ and the price index of identical basket of products in India is Pr, then: Equation (i) Here St is the spot exchange rate at time t. Likewise, according to the version of relative PPP theory there is a link between expected exchange rate[St+1] and expected inflation rates () in two countries. Since the future price of a commodity is affected by the expected inflation rate, the price levels in India and US are affected by the expected inflation rates. When P0 is the current price level, and is the expected inflation rate, the price levels after a year will be P1 = P0(1+ ) In India: Pr1=Pr0(1+ r) In US: P$1=P$0(1+ $) The ratio of prices one year later is:

This can be written as St[(

as (

) is the current spot rate, St. Thus the expected

exchange rate one year later, St+1, is a ratio of the prices one year later. St+1= St[(
) ( )

Equation (ii)

The above equation can be rearranged as:

The left hand side can be written as 1+{[ St+1- St] St}, where [ St+1- St] St is nothing but the rate of change in the spot rate. Denoting [ St+1- St] St by e: (1+e)= (
)

On simplification e=

(1+ )

The denominator on the right hand side (1+ ) can be ignored for small values of . Then [ St+1- St] St= Equation (iii) . Since e is nothing but [ St+1-

This equation states that e is approximately equal to

St] St , the relative version of PPP theory states that the rate of change in the spot rate is approximately equal to the inflation differential in two countries. When this condition holds true, the market is in equilibrium.