The theory of purchasing power parity (PPP) has a long history of several centuries, although the definition of PPP was still ambiguous at that time. The concept of purchasing power parity is firstly proposed in the sixteen century. Before the use of PPP, it was the gold standard that determined the exchange rate: exchange rate was directly linked to the gold standard without considering other factors such as inflation. However, the World War I (WWI) led to vast inflation differential among countries that were involved in the war. The inflation gap can bring an outcome of overvaluation or undervaluation of currency under a fixed exchange rate. Hence, PPP was introduced formally by Gustav Cassel (1918) as a method to measure the value of a currency and as a more accurate standard for the exchange rate.
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The purchasing power parity has two versions, the absolute PPP and the relative PPP. The measurement is different: the former one calculates a price ratio of the same basket of goods, while the latter one is not limited to nominal price. Balassa (1964) also stated that the relative interpretation asserts that when compared with an equilibrium period, “changes in relative prices would indicate the necessary adjustments in exchange rates”. Additionally, the existence of arbitrage drives the balance of real exchange rate and the nominal exchange rate, thus making sure the maintenance of absolute PPP (the real exchange rate equals 1) theoretically. If the PPP does not hold, spectaculars could make a profit by purchasing undervalued products from one place and selling these products at a higher price in another place until the prices in different regions remain the same. In
The purchasing power parity has two versions, the absolute PPP and the relative PPP. The measurement is different: the former one calculates a price ratio of the same basket of goods, while the latter one is not limited to nominal price. Balassa (1964) also stated that the relative interpretation asserts that when compared with an equilibrium period, “changes in relative prices would indicate the necessary adjustments in exchange rates”. Additionally, the existence of arbitrage drives the balance of real exchange rate and the nominal exchange rate, thus making sure the maintenance of absolute PPP (the real exchange rate equals 1) theoretically. If the PPP does not hold, spectaculars could make a profit by purchasing undervalued products from one place and selling these products at a higher price in another place until the prices in different regions remain the same. In