Purchasing Power Parity

Purchasing Power Parity

Purchasing Power Parity, a theory propounded by the Swedish economist Gustav Cassel in 2013 that claimed to explain international exchange rates between currencies in terms of the purchasing power in their home countries. Thus if people in Britain bought what bought in U.S.A., the equilibrium exchange rate would be = r. This is often not true; for some years the exchange rate was 17% but it did not indicate the relative purchasing power of the two currencies at home. The theory has a more valid form in which it tries to explain changes in the foreign exchange rate by changes in the relative purchasing power of the two currencies. If inflation takes place in one of the countries the domestic purchasing power of its currency will fall as prices rise, but as prices rise its products will become more expensive to foreigners while its own citizens will tend to buy relatively cheaper imports rather than home-produced goods: thus, if capital flows do not alter, the reduced foreign demand for its currency and its own increased demand for foreign currencies will cause its exchange rate to depreciate. This is the best case that can be made for the theory. Even so, it is open to criticism: e.g. the wartime sale of foreign assets by Britain, which reduced her foreign investment income and necessitated increased sales of export goods, required a larger post war change in the exchange rate than would have been necessary merely to preserve parity of relative internal purchasing powers of dollars and pounds. The basic explanation of the foreign exchange rate is that it depends on supply and demand, and purchasing power is only one influence among many that determine supply and demand. Others are changes in national income, in productivity (e.g. in export industries) and in the flow of capital. If British investors wish to buy assets and make loans abroad without any matching desire by foreigners to lend to Britain, the exchange rate will tend to depreciate. Purchasing power parity is thus only a partial explanation of exchange rates, although when other circumstances are generally stable it can give a rough guide to them.

Pure Competition, one of a number of economic 'models' of market forms used in economic analysis which range from pure competition through monopolistic competition and oligopoly to pure monopoly. The model of pure competition assumes many sellers (in relation to total output) of identical products none of whom can influence the market price by varying the amount he sells. Under the assumptions every firm would be maximizing profits when it had expanded output to the level at which the additional (marginal) cost of producing additional units of output was just equal to the market price of additional units. Expressed another way, it would expand its hire of factors to the point at which additional input factors of production made an output contribution just equal in value to their cost. Both these statements infer that the price consumers would be willing to pay for additional units if output was just equal to the cost of bidding away from alternative uses the factors of production necessary to produce them.

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