lthough a relationship between the exchange rate and price levels was suspected as early as the 1600's (Isard p57), it was not until 1918 that this link became known as the purchasing power parity or PPP. Essentially PPP rests on the notion that people pay one price for goods, so that a good in one country will be as cost the same as it does in another country. If there was a difference in price between the two countries, people would simply buy the good in the "cheaper" country and bring it back home where they could sell it and thereby forcing the price in their home country down until the prices in both country are the same. This practice is known as arbitrage. From these assumptions we can extrapolate that the exchange rate must be equal to the ratio of price levels of the two countries:Where S is the exchange rate and P is the domestic price level and P* the foreign price level.Unfortunately such a proposition is impossible to evaluate. The price levels are difficulty quantifiable. Think of it as asking someone to determine how much he or she enjoys a movie. Clearly one cannot simply say "oh it was about 6" and expect the questioner to understands what the answer means. The way to properly answer the question is to provide a frame of reference for your answer, for example saying "it was a 6 out of 10." Even then your criteria for a 6 could be much different then someone else. The same rational applies to price levels. In order to compare two price levels it is necessary to view price levels as the cost of a basket of the goods. However it is also necessary for those baskets to contain exactly the same goods. Moreover, the goods must also be tradable; the PPP works only if arbitrage is allowed to occur. Therefore when testing PPP we must use price indices which trace the cost of a basket of goods over a number of years relative to a base year. Thus, we are actually taking the ratio of the rates of change in the price lev...
