The purchasing power parity theory

The purchasing power parity theory, as formulated by Cassel, may best be summed up by quoting the following passage from Money and Foreign Exchanges after 1914:

'Our willingness to pay a certain price for foreign money must ultimately and essentially be due to the fact that this money possesses purchasing power as against commodities and services in that foreign country.... Our valuation of a foreign currency in terms of our own, therefore, mainly depends on the relative purchasing power of the two currencies in their respective countries.... When the two currencies have undergone inflation, the normal rate of exchange will be equal to the old rate multiplied by the quotient of the degree of inflation in the one country and in the other.... The rate that has been calculated by the above method must be regarded as the new parity between the currencies, the point of balance towards which, in spite of all temporary fluctuations, the exchange rates will always tend. This parity I call purchasing power parity.'

Initial support to Cassel's theory came mainly from Germany and Central Europe. Ellis quoted a pamphlet, published in Vienna by Schlesinger almost simultaneously with Cassel's articles, which argued that the true parity was the ratio between domestic and foreign prices. 6 He also quoted Lansburgh, a monetary economist with practical experience in banking, who sharply criticised the Reichsbank for denying that the depreciation of the mark exchange was due to inflation, and for trying to explain it entirely on the basis of the balance of payments theory. Hahn drew distinction between the 'static' rate of exchange represented by mint parities or purchasing power parities, and the 'dynamic' rate which deviates from either parity; thereby he revived under another name the familiar differentiation applied in past centuries.

In the United States the purchasing power parity theory found an early supporter in Noyes, who, writing in 1916, remarked: 'It is impossible to escape the conclusion that the depreciation in the German rate measured largely, and in fact primarily, the depreciation of the German currency.' After the war Cassel's theory received strong support in Britain, in particular from Keynes, Gregory and Pigou. Keynes later claimed that he never endorsed the purchasing power parity theory entirely without reservations and, in subsequent years, came to lay increasing stress on the reservations. Pigou and Gregory, on the other hand, wholeheartedly endorsed the theory in its original form.