Purchasing Power Parity (PPP)

The purchasing power parity theory establishes the idea that

the ratio of price level and exchange rate between two
countries must be equivalent.
PPP means that the same goods or basket of goods should
sell at the same price in different countries when measured in a
common currency , in absence of transactions costs.

Two Versions of PPP Theory

1) Absolute or Positive Version: According to the absolute
version of Purchasing Power Parity (PPP) theory, the
exchange rate between two currencies should reflect the
relation between the international purchasing power of
various currencies.
For example, suppose particular basket of goods cost
1,000in India and $100 in U.S.A. That means the exchange
rate would be 10=$1.

2) Relative or Comparative Version: The relative version was

put forward by Cassel in order to find the strength of the
changes in the equilibrium exchange rate. Any departure from
the equilibrium will lead to the disequilibrium. It can take
place due to change in the internal purchasing power of a
particular currency.