Steps taken to stimulate the world economy after World War 1 and World War 2 and the degree of success for the two approaches
By the time the Second World War ended; more than forty million people died from violence and starvation. Both the first and the second world wars left destruction in the economies of the war participants. As such, economic stimuli have to be adopted in a bid to reconstruct the world economy. World War 1 resulted in trade barriers that led to global depression. The United States adopted some plans to stimulate the economy after the war. These included wartime production, central planning and government initiatives. Millions of homecoming soldiers were incorporated into the growing economy. The four main economic controls adopted by the European belligerents and later by America as a latecomer include the food administration, fuel administration, war industries and railroad administration. The duty of food administration was to encourage the production of food and make sure there was equitable distribution among civilians, the allies and the armed forces at a reasonable price. The food and fuel act was put in place to control markups of food processors and distributors (Rockoff, 2010, para 6).
Voluntary cooperation at the retail level was encouraged to control inflation, and consumers were urged to reduce their consumption on valuable foodstuffs such as Wheatless Wednesdays. Fuel administration was set to control the price and distribution of bituminous coal resulting from a coal shortage that led to industrial unit closures. The administration of fuel set the price of coal at the mines and dealers’ profits, settled disputes in the coalfield, as well as working with other economic agents like railroad administration to lessen coal lengthy haul. Railroad administration was put in place to help ease the railway network congestion, resulting from delays in the movement of goods for use during the war and coal. The war industries board was responsible for setting prices of industrial based goods like rubber, iron, coal and steel. The America government institutions also gave special attention to business interests, as capital that was held in the private sector due to war uncertainties was made available. The reason is that the government changed its tax policies to support investment. The responsible for Federal Reserve maintained interest at low levels in order to stimulate capital formation for building a large business enterprise in 1919 (Herren, Ruesch & Sibille, 2011, 34;).
The American government supported advances in technology which further stimulated the business sector. Farm and industry productivity augmented due to new chemical fertilizers and refinements in the industry, but the aspect of trade barriers after World War 1 led to difficulties in obtaining markets for the increased production in America. In the meanwhile, Europe was struggling to obtain raw materials for its industries, particularly the meal industry. Businesses wanted advertising experts to look for customers, and the economy turned from production oriented to consumer oriented. Financial institutions made loans available, and other businesses extended credit to enhance sales. Customers were ready to pay any price for deliveries; there was full economy. The expanded economy absorbed the oncoming veterans of war. Instead of becoming a burden on the labor market, the war veterans represented a vast new consumer market. As such, 1919 was a great trading year with contractive and expansive forces. The progress of demobilization and reconversion essentially determined the economic trends. Cut backs on war production were offset by the expansion of peacetime industries (Knutsen, 1999, p 192).
Employment in factories declined, apparently resulting from layoffs in munitions industries and withdrawal of emergency war employees, the increasing demand for labor and the enlarging peacetime production. After the Second World War, steps were taken to ensure a more open global economy. That economic order along with technological advances gave rise to new economic growth in many developing countries and the industrialized nations. Recovery for Europe recovery after the Second World War almost came to a stand in 1947. Foreign assets reserves got depleted; earnings on export were inadequate for financing purchases of equipments and raw materials from America, which was the only functioning economy by then. Europe’s earnings were insufficient to offer savings required to finance reconstruction. Taxes were inadequate to support the budget as financial wars and inflation ate into Europe’s ability to reorganize and reconstruct its economy. In order to prevent the European countries from plunging into a humanitarian crisis, the Marshall Plan economic stimulus was adopted. The plan gave resources to finance public expenditure and finance investment, whilst allowing countries to import from the U.S. The plan eradicated bottlenecks that hindered growth and set the arena for prosperity, compared to the programs adopted after World War 1 that centered on control. Marshall Plan was a multi-year commitment to cater for European recovery. The first year of the plan was committed to food, where more than sixty percent was utilized on primary products and intermediate inputs like foods, fertilizers and feeds. The remnants were allocated fuel, machinery and automobiles. Industrial production recovered more than agricultural output after the Second World War (Beckmann & Simon, 2009, 114).
One of the aims of the Marshall plan was to accelerate private investment by offering capital to a poor postwar Europe. Countries that received money invested more in new investments whose returns were high. The plan also offered funds for financing public expenditure on infrastructure. Ports, railroads, bridges and roads had been severely ruined by the war as they were the primary targets. Additionally, the Marshall plan helped put bottlenecks and foreign exchange constraints under check. Marshall Plan funds were in the form of hard currency, which enabled Europe to obtain imports in a dollar-scarce world (Barry & Portes, 1989, p, 22). Raw materials for European industries like cotton, coal, petroleum were in acute supply after the Second World War, and the plan made it possible to buy them at a higher rate than would be ordinarily possible. Funds from the plan also made it possible for intra-European trade. Marshall Plan played an essential role in restoring financial stability in the post-second world war Europe. After the First World War, governments responded to inflation by instituting controls, prompting the development of illegal markets. Agricultural producers refused to sell their produce as long as prices were controlled. Farmers were better off hoarding their inventories as proceeds were susceptible to taxation and inflation. The plan helped in the adoption of liberal market solution to decontrol prices, stop inflation and coax producers to bring their products to the market to allow price mechanism to function smoothly. For this to be achieved, the Marshall plan ensured that budgets were balanced, and inflation was stopped and that consumers accepted posted higher prices for necessities and foodstuff. The plan was comprehensive enough to allow employees to moderate their demands for higher wages. Taxpayers had to accept the burden of additional tax liabilities, as well as a expansive accord on a fair distribution of income (Forrest, 1990, p 48; Michael, 1987, P 103).
By contrast, Europe’s external state of affairs seemed more favorable after the First World War, as foreign investments were still large and shipping generated prospective net revenues. Most European nations regained access to the global capital markets after the First World War, unlike in the Second World War when its position to import commodities and draw resources from the entire world was compromised. Changes in net foreign asset position lessened the annual incomes from foreign net investments for Western Europe. Marshall Plan was successful than measures adopted after the First World War because it resulted in faster recovery. National product per capita in the largest west Europe countries fell at least 25 percent below the1938 prewar level. This was half again as production per capita in 1919 had slipped below its 1913 prewar level. After adoption of the Marshall plan, recovery soon surpassed that which followed the First World War. The national per capita of France, Britain and Germany recovered to almost reach the pre-war levels. By the effective end of the Marshall plan in 1951, national incomes per capita were ten percent above prewar levels. The major players in the Western Europe attained a degree of recovery in six years after world war two, which had not been attained in the sixteen years after world war one (Tyler, 1985, p 56; Barry, 1989, p 112).
Additionally, the production of coal after the Second World War outperformed that of post world war 1. Coal production fell by 11 percent from 83 percent in the pre-war period to 73 percent in 1920, as a result of deflation policy enforced by central banks in a bid to restore pre-world war gold war standard parities. No government pursued such a policy in the Second World War. Coal production dropped for the second time after WWI in 1922-23 that resulted in the Germany runway inflation. In 1926, coal production fell for a third time following attempts by the Britain government to return to gold in a bid to reduce wages, as a means of deflation. Wars of attrition were turbulent in the aftermath of world war one while Marshall Plan embraced for stimulating the economy after WWII resulted in more equitable distribution of resources (Marcello, 1986, p 109; Rolf, 1990, p 457).
In conclusion, Marshall Plan was more comprehensive in reconstruction the world after the Second World War as compared to the four elements of food administration, railroad administration, fuel administration and the war industries. Marshall Plan helped the European nations that had been devastated by the war to recover and rebuild their infrastructure and re-establish their trade position globally as the plan entailed more international cooperation.
The two forms of PPP theory, and the extent to which the two forms are valid
PPP is a theory regarding exchange and a tool to make more precise comparisons of data between countries. It is a concept of evolution of currencies. PPP assumes that the price for a similar product ought to be the same all over the globe. The theory holds that if a comparison of a similar basket worldwide is made in different currencies, then one ought to have a clue on a currency’s future fluctuation. PPP exchange rate is the rate of exchange between two currencies that would equate the two relevant national price levels if evaluated in a common currency at that rate, such that the buying power of an element of one currency would be similar in both countries. The element of purchasing power parity has two economic applications. First, PPP has a main use as a conversion factor to transfer data from denomination in one national currency to another. The data are mainly in a national accounts framework, though the extent of detail may range from the gross domestic product to more disaggregative classes of expenditure. This usage highlights a body of index number theory and applications in Intercountry comparisons of GDP that have gradually developed over the years. The second use of PPP is the theory of exchange, which has no much widespread acceptance among economists. The reason is that its theoretical usage depends on various assumptions that may not hold in the actual world. Additionally, the quantity of foreign exchange function as a result of exporter and importer demands is much less than the quantity of activity due to investor demands (Michael, 1987, p 233; Sarno &Taylor, 2002, p 68)
All parity conditions are founded on the arbitrage basis, which is purchasing an item at a cheaper price in one marketplace and selling it at a higher price in a different market. This law of one price holds that a product selling in a foreign country should sell at a similar price evaluated in the same currency as a product sold domestically. PPP theory states that the equilibrium rates of exchange between two national currencies, not in metallic standard have to equalize the buying power of the two currencies (Shrivastava, nd, p 79; Taylor & Taylor, 2004, p 139). If the U.S dollar buying power is three times that of the Y currency for a similar basket of products and services, then the equilibrium exchange rate ought to be $ 1= 3Y. The PPP theory has been presented in two main forms: the absolute PPP and the comparative/relative form.
Absolute form of PPP
The absolute form of PPP is founded on the idea that without international barriers; consumers change their demand to wherever prices are lower. It asserts that prices of a similar basket of products in two different countries ought to be equal when weighted in a universal currency. If an incongruity in prices as measured in common currency exists, the demand ought to change in order for these prices to converge. For instance, is a similar basket of products is produced by the united kingdom and the united states, and the price in the united states is lower when evaluated in a universal currency, the demand for that basket ought to increase in the United States and decrease in the United States. Both forces would cause the prices of the baskets to be similar when measured in a universal currency (Blanchard & Quah, 1989, p 657; Woytinsky, nd, p 24).
In verity, the presence of transportation costs, quotas, taxes and tariffs may obstruct the absolute form of PPP. If transport costs were high in the above U.K and the U.S example, the demand for a basket of products may not change as suggested. As such, the discrepancy in prices would continue. Absolute PPP holds that the rate of exchange S( expressed in units of domestic money per unit of overseas currency) and the levels of price in the two nations in consideration P ought to be related so that S=P/P*, where P= home price level and P*= the overseas price level. The absolute PPP holds that if the U.S price of a TV set is $ 200 and the rate of exchange S is $0.10 per pound, the price of the TV in U.K should be 200 ($0.10= $ 200/ U.K price). Otherwise, beneficial arbitrage would be possible. Suppose for instance the TV costs 1500 pounds in U.K. As entrepreneurs bought the TVs in U.K, the price will begin to increase on mounting demand. The TVs will be shipped to the United States and traded there, escalating the U.S supply and making the price to decrease. If this happens for enough products and services, the demand for the pound would also rise, eventually increasing the value of the pound. If the TV example was to extend to all products and services, then it would mean that S= index of average prices in the U.S/ index of standard prices in U.K; S= P/P*. If the U.K level of price is 1200 and the United States price level is 120, apparently the rate of exchange ought to be S= 120/1200 giving a rate of $ 0.10. Absolute PPP does not for two countries as a result of the implied assumptions. Absolute theory ignores transport costs and the risks associated with transporting goods globally. It also assumes that consumers in the two countries in consideration do not value the baskets equally (Alesina & Perotti, 1995, p, 963; Bouvier, nd, 6; Taylor, 2001, p 480).
Relative PPP
The relative form PPP accounts for the possibility of market flaws like transport costs, quotas and tariffs. Relative version of PPP recognizes that as a result of these market flaws, prices of a similar basket of products in different countries will not necessarily be equal when weighed in a common currency. Relative PPP also avoids the implication that the exchange rate is always equal to one since S= P/P*, and the actual rate of exchange has to be 1= (P/P*) × (P*/P). This is untrue as people in different countries purchase products and services in varying proportions. The percentage change in the exchange rate according to relative PPP= %ΔP-%ΔP*, such that the percentage change in the exchange rate for two countries’ currencies equals the differential between the two states’ inflation rates (Taylor, 2001, p 476).
Relative PPP states that the rate of change in the prices of a basket ought to be somehow alike when evaluated in a universal currency, as long as barriers to trade and transport costs are not altered. For instance, let’s assume that the U.K and the U.S trade expansively with each other and at first have zero inflation, and another assumption that the U.S experiences a 9 percent inflation rate, whereas the U.K experiences a 4% inflation. In this state of affairs, relative PPP theory holds that the British pound ought to appreciate by about five percent, which is the difference in the inflation rate. Given U.K inflation of 4 percent and appreciation of the pound by five percent, consumers in the U.S will be paying approximately nine percent extra for the U.K products than they paid in the beginning equilibrium state. This is equal to the nine percent increase in prices of U.S goods from the U.S inflation. The rate of exchange ought to adjust to offset the difference in the inflation rates of the two nations such that the prices of commodities in the two states have to appear alike to consumers. The operation behind the comparative PPP hypothesis is that rate of exchange change is essential for the relative buying power to be similar whether in buying products locally or from another country. If the buying power is not the same, customers will change purchases to where products are less expensive awaiting the purchasing power to be equal. For instance, if the dollar appreciated by a single one percent in reaction to inflation (Taylor et al 2005, p 295; Vij, 2006, p 212).
In conclusion, absolute PPP differs from relative PPP in that it refers to the equalization of the actual price levels across nations, whilst relative PPP holds that the percentage change in exchange rates, over any period, equals the differential in proportion price changes of different states. As such, relative PPP offers a more realistic view of the exchange rate as it incorporates transport costs and other elements like taxation and quotas assumed by the absolute PPP.
By the time the Second World War ended; more than forty million people died from violence and starvation. Both the first and the second world wars left destruction in the economies of the war participants. As such, economic stimuli have to be adopted in a bid to reconstruct the world economy. World War 1 resulted in trade barriers that led to global depression. The United States adopted some plans to stimulate the economy after the war. These included wartime production, central planning and government initiatives. Millions of homecoming soldiers were incorporated into the growing economy. The four main economic controls adopted by the European belligerents and later by America as a latecomer include the food administration, fuel administration, war industries and railroad administration. The duty of food administration was to encourage the production of food and make sure there was equitable distribution among civilians, the allies and the armed forces at a reasonable price. The food and fuel act was put in place to control markups of food processors and distributors (Rockoff, 2010, para 6).
Voluntary cooperation at the retail level was encouraged to control inflation, and consumers were urged to reduce their consumption on valuable foodstuffs such as Wheatless Wednesdays. Fuel administration was set to control the price and distribution of bituminous coal resulting from a coal shortage that led to industrial unit closures. The administration of fuel set the price of coal at the mines and dealers’ profits, settled disputes in the coalfield, as well as working with other economic agents like railroad administration to lessen coal lengthy haul. Railroad administration was put in place to help ease the railway network congestion, resulting from delays in the movement of goods for use during the war and coal. The war industries board was responsible for setting prices of industrial based goods like rubber, iron, coal and steel. The America government institutions also gave special attention to business interests, as capital that was held in the private sector due to war uncertainties was made available. The reason is that the government changed its tax policies to support investment. The responsible for Federal Reserve maintained interest at low levels in order to stimulate capital formation for building a large business enterprise in 1919 (Herren, Ruesch & Sibille, 2011, 34;).
The American government supported advances in technology which further stimulated the business sector. Farm and industry productivity augmented due to new chemical fertilizers and refinements in the industry, but the aspect of trade barriers after World War 1 led to difficulties in obtaining markets for the increased production in America. In the meanwhile, Europe was struggling to obtain raw materials for its industries, particularly the meal industry. Businesses wanted advertising experts to look for customers, and the economy turned from production oriented to consumer oriented. Financial institutions made loans available, and other businesses extended credit to enhance sales. Customers were ready to pay any price for deliveries; there was full economy. The expanded economy absorbed the oncoming veterans of war. Instead of becoming a burden on the labor market, the war veterans represented a vast new consumer market. As such, 1919 was a great trading year with contractive and expansive forces. The progress of demobilization and reconversion essentially determined the economic trends. Cut backs on war production were offset by the expansion of peacetime industries (Knutsen, 1999, p 192).
Employment in factories declined, apparently resulting from layoffs in munitions industries and withdrawal of emergency war employees, the increasing demand for labor and the enlarging peacetime production. After the Second World War, steps were taken to ensure a more open global economy. That economic order along with technological advances gave rise to new economic growth in many developing countries and the industrialized nations. Recovery for Europe recovery after the Second World War almost came to a stand in 1947. Foreign assets reserves got depleted; earnings on export were inadequate for financing purchases of equipments and raw materials from America, which was the only functioning economy by then. Europe’s earnings were insufficient to offer savings required to finance reconstruction. Taxes were inadequate to support the budget as financial wars and inflation ate into Europe’s ability to reorganize and reconstruct its economy. In order to prevent the European countries from plunging into a humanitarian crisis, the Marshall Plan economic stimulus was adopted. The plan gave resources to finance public expenditure and finance investment, whilst allowing countries to import from the U.S. The plan eradicated bottlenecks that hindered growth and set the arena for prosperity, compared to the programs adopted after World War 1 that centered on control. Marshall Plan was a multi-year commitment to cater for European recovery. The first year of the plan was committed to food, where more than sixty percent was utilized on primary products and intermediate inputs like foods, fertilizers and feeds. The remnants were allocated fuel, machinery and automobiles. Industrial production recovered more than agricultural output after the Second World War (Beckmann & Simon, 2009, 114).
One of the aims of the Marshall plan was to accelerate private investment by offering capital to a poor postwar Europe. Countries that received money invested more in new investments whose returns were high. The plan also offered funds for financing public expenditure on infrastructure. Ports, railroads, bridges and roads had been severely ruined by the war as they were the primary targets. Additionally, the Marshall plan helped put bottlenecks and foreign exchange constraints under check. Marshall Plan funds were in the form of hard currency, which enabled Europe to obtain imports in a dollar-scarce world (Barry & Portes, 1989, p, 22). Raw materials for European industries like cotton, coal, petroleum were in acute supply after the Second World War, and the plan made it possible to buy them at a higher rate than would be ordinarily possible. Funds from the plan also made it possible for intra-European trade. Marshall Plan played an essential role in restoring financial stability in the post-second world war Europe. After the First World War, governments responded to inflation by instituting controls, prompting the development of illegal markets. Agricultural producers refused to sell their produce as long as prices were controlled. Farmers were better off hoarding their inventories as proceeds were susceptible to taxation and inflation. The plan helped in the adoption of liberal market solution to decontrol prices, stop inflation and coax producers to bring their products to the market to allow price mechanism to function smoothly. For this to be achieved, the Marshall plan ensured that budgets were balanced, and inflation was stopped and that consumers accepted posted higher prices for necessities and foodstuff. The plan was comprehensive enough to allow employees to moderate their demands for higher wages. Taxpayers had to accept the burden of additional tax liabilities, as well as a expansive accord on a fair distribution of income (Forrest, 1990, p 48; Michael, 1987, P 103).
By contrast, Europe’s external state of affairs seemed more favorable after the First World War, as foreign investments were still large and shipping generated prospective net revenues. Most European nations regained access to the global capital markets after the First World War, unlike in the Second World War when its position to import commodities and draw resources from the entire world was compromised. Changes in net foreign asset position lessened the annual incomes from foreign net investments for Western Europe. Marshall Plan was successful than measures adopted after the First World War because it resulted in faster recovery. National product per capita in the largest west Europe countries fell at least 25 percent below the1938 prewar level. This was half again as production per capita in 1919 had slipped below its 1913 prewar level. After adoption of the Marshall plan, recovery soon surpassed that which followed the First World War. The national per capita of France, Britain and Germany recovered to almost reach the pre-war levels. By the effective end of the Marshall plan in 1951, national incomes per capita were ten percent above prewar levels. The major players in the Western Europe attained a degree of recovery in six years after world war two, which had not been attained in the sixteen years after world war one (Tyler, 1985, p 56; Barry, 1989, p 112).
Additionally, the production of coal after the Second World War outperformed that of post world war 1. Coal production fell by 11 percent from 83 percent in the pre-war period to 73 percent in 1920, as a result of deflation policy enforced by central banks in a bid to restore pre-world war gold war standard parities. No government pursued such a policy in the Second World War. Coal production dropped for the second time after WWI in 1922-23 that resulted in the Germany runway inflation. In 1926, coal production fell for a third time following attempts by the Britain government to return to gold in a bid to reduce wages, as a means of deflation. Wars of attrition were turbulent in the aftermath of world war one while Marshall Plan embraced for stimulating the economy after WWII resulted in more equitable distribution of resources (Marcello, 1986, p 109; Rolf, 1990, p 457).
In conclusion, Marshall Plan was more comprehensive in reconstruction the world after the Second World War as compared to the four elements of food administration, railroad administration, fuel administration and the war industries. Marshall Plan helped the European nations that had been devastated by the war to recover and rebuild their infrastructure and re-establish their trade position globally as the plan entailed more international cooperation.
The two forms of PPP theory, and the extent to which the two forms are valid
PPP is a theory regarding exchange and a tool to make more precise comparisons of data between countries. It is a concept of evolution of currencies. PPP assumes that the price for a similar product ought to be the same all over the globe. The theory holds that if a comparison of a similar basket worldwide is made in different currencies, then one ought to have a clue on a currency’s future fluctuation. PPP exchange rate is the rate of exchange between two currencies that would equate the two relevant national price levels if evaluated in a common currency at that rate, such that the buying power of an element of one currency would be similar in both countries. The element of purchasing power parity has two economic applications. First, PPP has a main use as a conversion factor to transfer data from denomination in one national currency to another. The data are mainly in a national accounts framework, though the extent of detail may range from the gross domestic product to more disaggregative classes of expenditure. This usage highlights a body of index number theory and applications in Intercountry comparisons of GDP that have gradually developed over the years. The second use of PPP is the theory of exchange, which has no much widespread acceptance among economists. The reason is that its theoretical usage depends on various assumptions that may not hold in the actual world. Additionally, the quantity of foreign exchange function as a result of exporter and importer demands is much less than the quantity of activity due to investor demands (Michael, 1987, p 233; Sarno &Taylor, 2002, p 68)
All parity conditions are founded on the arbitrage basis, which is purchasing an item at a cheaper price in one marketplace and selling it at a higher price in a different market. This law of one price holds that a product selling in a foreign country should sell at a similar price evaluated in the same currency as a product sold domestically. PPP theory states that the equilibrium rates of exchange between two national currencies, not in metallic standard have to equalize the buying power of the two currencies (Shrivastava, nd, p 79; Taylor & Taylor, 2004, p 139). If the U.S dollar buying power is three times that of the Y currency for a similar basket of products and services, then the equilibrium exchange rate ought to be $ 1= 3Y. The PPP theory has been presented in two main forms: the absolute PPP and the comparative/relative form.
Absolute form of PPP
The absolute form of PPP is founded on the idea that without international barriers; consumers change their demand to wherever prices are lower. It asserts that prices of a similar basket of products in two different countries ought to be equal when weighted in a universal currency. If an incongruity in prices as measured in common currency exists, the demand ought to change in order for these prices to converge. For instance, is a similar basket of products is produced by the united kingdom and the united states, and the price in the united states is lower when evaluated in a universal currency, the demand for that basket ought to increase in the United States and decrease in the United States. Both forces would cause the prices of the baskets to be similar when measured in a universal currency (Blanchard & Quah, 1989, p 657; Woytinsky, nd, p 24).
In verity, the presence of transportation costs, quotas, taxes and tariffs may obstruct the absolute form of PPP. If transport costs were high in the above U.K and the U.S example, the demand for a basket of products may not change as suggested. As such, the discrepancy in prices would continue. Absolute PPP holds that the rate of exchange S( expressed in units of domestic money per unit of overseas currency) and the levels of price in the two nations in consideration P ought to be related so that S=P/P*, where P= home price level and P*= the overseas price level. The absolute PPP holds that if the U.S price of a TV set is $ 200 and the rate of exchange S is $0.10 per pound, the price of the TV in U.K should be 200 ($0.10= $ 200/ U.K price). Otherwise, beneficial arbitrage would be possible. Suppose for instance the TV costs 1500 pounds in U.K. As entrepreneurs bought the TVs in U.K, the price will begin to increase on mounting demand. The TVs will be shipped to the United States and traded there, escalating the U.S supply and making the price to decrease. If this happens for enough products and services, the demand for the pound would also rise, eventually increasing the value of the pound. If the TV example was to extend to all products and services, then it would mean that S= index of average prices in the U.S/ index of standard prices in U.K; S= P/P*. If the U.K level of price is 1200 and the United States price level is 120, apparently the rate of exchange ought to be S= 120/1200 giving a rate of $ 0.10. Absolute PPP does not for two countries as a result of the implied assumptions. Absolute theory ignores transport costs and the risks associated with transporting goods globally. It also assumes that consumers in the two countries in consideration do not value the baskets equally (Alesina & Perotti, 1995, p, 963; Bouvier, nd, 6; Taylor, 2001, p 480).
Relative PPP
The relative form PPP accounts for the possibility of market flaws like transport costs, quotas and tariffs. Relative version of PPP recognizes that as a result of these market flaws, prices of a similar basket of products in different countries will not necessarily be equal when weighed in a common currency. Relative PPP also avoids the implication that the exchange rate is always equal to one since S= P/P*, and the actual rate of exchange has to be 1= (P/P*) × (P*/P). This is untrue as people in different countries purchase products and services in varying proportions. The percentage change in the exchange rate according to relative PPP= %ΔP-%ΔP*, such that the percentage change in the exchange rate for two countries’ currencies equals the differential between the two states’ inflation rates (Taylor, 2001, p 476).
Relative PPP states that the rate of change in the prices of a basket ought to be somehow alike when evaluated in a universal currency, as long as barriers to trade and transport costs are not altered. For instance, let’s assume that the U.K and the U.S trade expansively with each other and at first have zero inflation, and another assumption that the U.S experiences a 9 percent inflation rate, whereas the U.K experiences a 4% inflation. In this state of affairs, relative PPP theory holds that the British pound ought to appreciate by about five percent, which is the difference in the inflation rate. Given U.K inflation of 4 percent and appreciation of the pound by five percent, consumers in the U.S will be paying approximately nine percent extra for the U.K products than they paid in the beginning equilibrium state. This is equal to the nine percent increase in prices of U.S goods from the U.S inflation. The rate of exchange ought to adjust to offset the difference in the inflation rates of the two nations such that the prices of commodities in the two states have to appear alike to consumers. The operation behind the comparative PPP hypothesis is that rate of exchange change is essential for the relative buying power to be similar whether in buying products locally or from another country. If the buying power is not the same, customers will change purchases to where products are less expensive awaiting the purchasing power to be equal. For instance, if the dollar appreciated by a single one percent in reaction to inflation (Taylor et al 2005, p 295; Vij, 2006, p 212).
In conclusion, absolute PPP differs from relative PPP in that it refers to the equalization of the actual price levels across nations, whilst relative PPP holds that the percentage change in exchange rates, over any period, equals the differential in proportion price changes of different states. As such, relative PPP offers a more realistic view of the exchange rate as it incorporates transport costs and other elements like taxation and quotas assumed by the absolute PPP.
