What do you Mean by Inflation and Purchasing Power Theory? 

In economic terms, Inflation refers to the increase in the costs of various commodities which are used in daily lifestyle like food, clothes, transport, etc. over a specific time. It may lead to a fall in the purchasing power of the people and also affects the exchange rate of the currency because of the price increase. As the purchasing power falls the unit of the currency in the economy falls. When the prices of the commodities are decreased, then the purchasing power of the consumers will rise, then it will lead to deflation and changes the currency of the base economy to that of the foreign economy which will lead to change in exchange rates.

How is Inflation caused? 

There are three factors by which it is caused. 

• Demand-pull: It occurs when there is more demand for the products/services by the consumers than their actual supply which increases the prices of the products/services demanded. It also refers to the term where there is a rise in prices of the commodities and the supply of such commodities is less.
• Cost-push: It refers to the situation where the cost of manufacturing the products/services increases, which causes the manufacturers to increase the cost of the products/services.
• Built-in: It means the demand of laborers to increase their wages/salaries to meet the cost of living which results in increasing the prices of the products/services to meet the increasing demand of laborers to raise the wages/salaries.

Effects

It can impact in positive as well as negative ways the economy. If the currency is decreasing, then exports can be benefitted as it makes the exports of the products/services at low prices in the foreign market. The imports on the other hand will fall as it causes the foreign products/services more costly than they cost. Consumers may have fewer savings as compared to the expenses during the rising price time. When there was a recession in the United States, it affected the whole world even India also. Many people in India also lost their jobs due to the recession in the U.S. as the price of US dollars got affected largely.

Calculation: It is calculated by the below formula:

$\begin{array}{l}PercentageInflationRate=CurrentCPI–\frac{PastCPI}{CurrentCPI}\times 100or\hfill \\ =\frac{B-A}{A}\times 100\hfill \end{array}$

Where CPI is the Consumer Price index

B is Current CPI, A is Past CPI.

*Consumer Price Index (CPI): The Consumer Price Index calculates the change in price which a consumer pays earlier to the current prices of various commodities.

Example: In 2011, the price of Petrol was 65.64 in New Delhi. With the time, in 2020, the price of petrol rises to 82.34. Calculate the Inflation rate?

Solution:

$\begin{array}{c}\begin{array}{l}PercentageInflationRate=\frac{CurrentCPI–PastCPI}{CurrentCPI}\times 100\hfill \\ =\frac{82.34-65.64}{82.34}\times 100\hfill \end{array}\\ =2.62\%\end{array}$

The percentage change is 2.62% in New Delhi.

What happens when Inflation is too high? 

If the rate is too high then there will be more unemployment and it will lead the economy to drop rapidly if it is not checked at the regular time. It slows down the development process as well of the country. Economist sees it in a positive direction, as there is more supply of money than the demand of money. It rise consumer demand and consumption which helps in economic growth.

How it can be stopped? 

To stop it government should use wage and price control methods, but these methods can also cause a recession and make people lost their jobs. Governments can also reduce the money supply by decreasing bond rates and rising interest rates.

What is Purchasing Power? 

In economic terms, purchasing power means the number of consumable commodities a unit of currency can buy by the consumers. It causes a decrease in the buying power of various commodities. It also reduces the savings of the consumers.

Purchasing Power Parity (PPP) Theory

Purchasing Power Parity Theory refers to the impact of inflation on the purchasing power of the people and the exchange of currency in the economy. The countries calculate buying power by Purchasing Power Parity (PPP) when the products/services are affordable for other exchange aspects. PPP is used to differentiate the income levels in different economies.

Purchasing Power Parity or PPP makes it easy to differentiate the data between the economies.

Absolute Purchasing Power Parity (PPP)  

It means the cost of the products/services reaches the equilibrium i.e their value is the same in different countries. The Absolute Purchasing Power Parity (PPP) or Absolute PPP is measured by the ratio of the price of commodities in one country's currency and another country’s currency.

Gross Domestic Product (GDP) and PPP 

Gross domestic product (GDP) is the overall monetary or market value of all the complete goods and services. Thus, this monetary or market value of all the utter (complete) goods and services produced. Primary within a country's boundary in a proper time. The growing economy is the growth rate of GDP. There are three methods to calculate GDP. However, After a diffuse computation of each domestic production. PPP studies the comparison of economic productivity and living standards between the economies. Some economies adjust their GDP numbers to reflect PPP. 

Price level adjustments under Purchasing Power Parity or PPP for exchanging rates 

In Purchasing Power Parity Theory or PPP theory, the price level is made by adjusting the price level between the economies. As it is assumed that the quantities of the products/services are fixed so the only way left to change the cost is to change the prices. So, the change in price level depicts the rising price rate which may also change the exchange rate.

For example: if the cost of a tablet was $800 two years ago and today they cost $550, the buyers may see their buying power has risen. Therefore, in the absence of inflation, $800 will now buy a tablet plus an additional $550 worth of goods.

Long-time buyers/manufacturers know that the purchasing power can largely impact consumers' investments. With all other things being equal, it reduces the number of products/services a consumer will be able to buy with the same amount of money. So the manufacturers will look ways for to get higher returns than the current rate.

Relationship between Inflation and Purchasing Power Parity (PPP) 

It is a universal occurrence in buying power. It can be explained with the help of an illustration:

Today with $1000 a very small quantity of fuel can be purchased but it was not 10 years ago, we could purchase some more than today. Therefore, it directly reduces the purchasing power of the consumer as at which price they used to purchase the same products/services are now costlier and they get small quantities with the same amount of money, this is defined as inflation.

Key Takeaway 

• A country’s CPI is calculated as the cost of products/services in the current year divided by the cost of products/services last year.
• The Purchasing Power Parity or PPP exchange rate can be calculated as CPI in the current year by the PPP exchange rate in the last year's country’s CPI.
• An increase in the price in the United States will increase the US Dollar rates in the global market.
• If the rate is high in the United States then the dollar rate will decrease in the global exchange between the countries.
• Purchasing Power Parity or PPP will not be adjusted between the exchange markets when the cost of transport and taxes are included in the commodities as it is based on the law of one price.
• Relative PPP or Relative Purchasing Power Parity relates to the increase/decrease of rates in different countries.
•  A currency’s overvaluation and undervaluation depend on the two factors 1. The cost will satisfy the Purchasing Power Parity (PPP).2 The amount that shows the account balances.
• The terms overvaluation and undervaluation depict the “proper” cost for the exchange rates between the countries.

• Whereas, in the floating exchange rate system the ‘proper’ exchange rates refer to the equalization of demand and supply of currencies used in the exchange.
• The use of Purchasing Power Parity (PPP) exchange rates helps to convert income data to a common currency so that there can be a better comparison between the differential cost of living.
• The term used for converting the units of data to US dollars using PPP exchange rates is “International dollars.”
• Absolute Purchasing Power Parity or Absolute PPP means that the prices must be the same between all the countries.

Common Mistakes 

Some common mistakes are made by the individuals in understanding the Inflation and Purchasing Power Parity. These are as follows: 

• Students may get confused regarding the increase in the general price level and its overall impact on the economy.
• Purchasing Power Parity does not give assurance to a consumer at the time of the rising inflation rate.

Context And Applications 

This topic is significant in the professional exams for both undergraduate and graduate courses, especially for 

• B.A in Economics 
• M.A in Economics 

Related Concepts

• GDP 
• Unemployment