Reasons why the Power of Purchasing Parity theory is effective

a) Strong relation between exchange rate and purchasing power of two countries currency and its rate of exchange:

Practically there is no defined link that exist between power to purchase the currency and its exchange rate. Apart from power to purchase, there is exchange rate which is influenced due to various factors like flow of capital, balance of payment, tariff and speculation. As these have not been considered, the purchasing power parity is not giving the desired forecast.
b) Level of prices:

This theory calculates the rate of exchange by using indices of price level in both countries as generic version. In general price level is inclusive of prices which are domestic and internationally traded and the theory is based on implicit assumption that prices in two segment of goods shows variation equally and proportionately assuming that it is in same path in both countries. It is seen that prices can move in any direction internal as well international. International trading of goods is not taken into account. As per this, prices of goods produced and used in home country will not have much impact on exchange rate.
c) Price Index Numbers:

Another issue in this theory, is using price index based on power to purchase a currency in two different countries. Price index numbers may be varying kind that raise issue of selecting the correct price index. Another problem which is based on price index of two countries is that it may not be comparable due to difference in same base period, choice of commodity and average pricing of each commodity. Keeping such diverse problem into account, constructing price index for two countries will be difficult as correct measurement of purchasing power parity is not available.

d) Price Level and Exchange Rate: PPP theory takes into account change in price level and it indicates that as cause for changing exchange rate. In other words, change in price level is cause and change in rate of exchange is effect. Changes in exchange rate can also lead to changes in price level. This can be faulty and misleading. In practical condition, depreciation in exchange rate stimulates export and gives restriction to imports. Reduction in supply for domestic market is likely reason for pushing the prices in upward direction in home country. In foreign country prices may fall, this will induce change in price level. Domestic prices are following the exchange rate rather than preceding.
e) Capital Account:

This theory has not taken into account capital transaction. It is considering only the Balance of Payment based on merchandising. Capital account which is significant in India is ignored. It seems to be more apt for trading nations and not so relevant when it comes trading and banking.
f) BOP Equilibrium:

In relative pattern, this theory assumes that balance of payment during the specified base time is in equilibrium. Assuming this, new rate of exchange is determined and such an assumption may not be true. It is difficult to locate such a period in any country due to unequal balance of payment.
g) Structure:

It is considering that there is no change in structure of factors, which are underlying the base time equilibrium. Factors like tastes, preference, resources, productivity and technology etc are considered. Assuming that related structural factors are unrealistic and rate of exchange are bound to be affected due to variation in factors.
h) Capital Movement:

PPP theory does not take into account variation of internal price which are changing in two countries. Zero capital investment is assumed and such assumptions do not give realistic results. Capital flow has substantial influence on exchange rate based on demand and supply of foreign as well as domestic currency. This impact of capital flow on exchange rate has been neglected in this theory.
i) Elasticity of demand and its reciprocal:

PPP fails to consider the reciprocal demand elasticity. Rate of exchange which are between two currency in two countries are determined not only due to changes in relative pricing but it takes into account the elasticity of reciprocal demand(Ca’Zorzi, M et al., 2016).
j) Barter Terms:

PPP depends on the assumption that there is no change in terms of bartering between two countries. Based on this assumption, the theory gets invalid. There are frequent changes in barter terms of trade due to several factors like export supply of goods, home demand for foreign goods, loans from foreign land etc.
k) Demand and Supply Forces:

Rate of exchange is not impacted by price change in two countries alone. Demand and supply of foreign exchange form fundamental force for determining rate of equilibrium. Other influencers are flow of capital, transportation cost, banking system, insurance system. PPP theory is not giving much importance to such forces of demand and supply of foreign exchange.
l) Income and Expenditure: Variation in aggregate level of income and expenditure and its effect on rate of exchange is not considered as per this theory. The effect of trading volume is not considered in this theory. As per this theory, demand is straight function of price wherein shift in income and expenditure in the business cycle is completely not taken into account. This leads to wide variation in volume and foreign exchange even if the prices remain the same.
m) International Economy:

This theory does not consider the cognizance and volatility of international business relationship. Third country purchasing commodity from first two countries who are already in trade relationship is not considered. Third country trading can have an impact on the demand and supply of goods and its volume. Hence proper measurement in multi country trading is not established.
n) Longevity:

PPP theory is apt for long period of time wherein not many other disturbances can have impact. However, price variation is one important aspect in exchange rate, it is not the only factor.
In spite of various weakness noticed in PPP theory, they form the central model and has proven to be good for long term analysis. Hence this theory has been considered for studying the exchange variation between EUR and USD. It is empirically proven theory, hence the same has been taken into account for the analysis of bilateral rate of exchange.

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