CPE 23 065-080 bzh004 FINAL 4/8/04 10:49 am Page 65

Contributions to Political Economy (2004) 23, 65–80

THE PURCHASING POWER PARITY THEORY

AND RICARDO’S THEORY OF VALUE

PABLO RUIZ-NÁPOLES*
Universidad Nacional Autonoma de México

In this paper the Purchasing Power Parity (PPP) theory and its criticisms are analysed.
The majority of studies show that in most cases, the PPP indicator is not a good pre-
dictor for nominal exchange rate changes, nor a good indicator of relative com-
petitiveness between countries. Instead, orthodox and non-orthodox economists use
relative labour costs to represent real exchange rates. This has interesting implica-
tions for the currently accepted price determination theory. In turn, this also allows
us to use a Ricardian model as developed by Pasinetti to calculate the ratio of real,
vertically integrated unit labour costs between countries as a real exchange rate
determination theory and as a sectoral relative competitiveness indicator as well.

If there is a topic of international economics on which economists have written more

than any other in the last 30 years, it is the exchange rate and, within it, the Purchas-
ing Power Parity (PPP) theory. Yet, little agreement has been reached about the
adequate measure of PPP and its importance in determining the exchange rate.
The purpose of this paper is to analyse the development of the PPP theory, to sum-
marise its main criticisms and to contrast it with the alternative cost-parity theories,
in particular with unit labour costs parity. It must be clear, though, that this is not a
survey of the PPP theory or of cost-parity theory, but only a summary of what we
consider are the most relevant arguments in the literature regarding real exchange rate
determination.
While some cost-parity approaches are developed within the neo-classical general
equilibrium framework, others are not, but are rather explicitly related to Ricardo’s
labour-theory of value. We present Ricardo’s labour-theory of value and natural prices
as interpreted by modern non neo-classical authors.
Finally, we develop a methodology to estimate unit labour costs, based on vertically
integrated labour coefficients, as an alternative theory for determining the real exchange
rate as well as sectoral relative competitiveness.

* The author is grateful to his colleagues, Martín Puchet, Professor at UNAM, and Juan C. Moreno,
research consultant at ECLA, UN, for their valuable comments on an earlier version of this paper.

Contributions to Political Economy, Vol. 23, © Cambridge Political Economy Society 2004, all rights reserved
CPE 23 065-080 bzh004 FINAL 4/8/04 10:49 am Page 66

66 P. RUIZ-NÁPOLES

I. EXCHANGE RATE AND RELATIVE PRICES:

PURCHASING POWER PARITY
The PPP theory establishes that the rate of exchange between two countries’ curren-
cies is the ratio of the prices of these two countries, measured in their own currencies.
To be a precise measure of purchasing power, these prices must include most of the
goods and services produced in each country. Thus, to formalise the PPP theory, we
have:

e  pi/pi* (1.1)

where e  the price of the foreign country currency measured in local currency units,
pi  domestic price of commodity i measured in domestic currency and pi*  foreign
price of i measured in foreign currency.
So the PPP theory, in its strict version, should say that the real exchange rate is
exactly equal to a ratio of two sets of prices: the domestic and the foreign. There is one
crucial assumption, namely that the ‘Law of One Price’ rules; that is to say, once free
trade opens up between any two countries, the price of any given commodity is the
same for both countries (measured in either currency) by virtue of supply and demand
operating in both markets at the same time.
To make this theory operational, i.e., to measure the purchasing power for any given
economy, the problem of adding prices is solved by the use of price indexes. So we
have:

P  f (p1 , p2 , . . . , pn) (1.2)

P f (
* *
p1*, p2*, ..., pn*) (1.3)

where P  price index of the home country in domestic currency and P*  price index
of the foreign country in the foreign country’s currency.1
Formally, this strong version of the PPP theory makes three assumptions: there is an
equalisation of prices across countries; the same goods enter into each country’s index
basket with the same weights; and f  f * in equations (1.2) and (1.3) (Dornbusch,
1988, p. 266). Then the absolute PPP equation is:

e  P/P* (1.4)

If pi/pi*  h for all i, then e  P/P*  h. This implies that P/P*·e  1 at all times.
Theoretically, under a flexible exchange rate and a free convertibility regime, the
adjustment between the nominal and the real exchange rate is assumed to be auto-
matic through the market mechanism. When the exchange rate is fixed, then

er/e  (P / E)  P* (1.5)

1
An interesting approach to the PPP measurement is the estimation of the relative price of a single
composite commodity. This is the case of the Big Mac index (see The Economist, 9 April 1998).
CPE 23 065-080 bzh004 FINAL 4/8/04 10:49 am Page 67

PURCHASING POWER PARITY THEORY 67

where er  real exchange rate, e  nominal exchange rate and E  nominal exchange
rate index (all indexes with the same base year). Equation (1.5) becomes

er  [ (P/E)  P* ] · e (1.6)

Depreciation raises e and E, so as to equate e to er estimated by equation (1.6). So

that in equilibrium er/e  1. However, these assumptions are not realistic; there are in
fact some obstacles to absolute free trade. Thus, a weak or relative version of the PPP
theory establishes that

e   (P/P*) (1.7)

where  is a constant, reflecting the given obstacles to trade. Given these obstacles, an
increase in the home price level, relative to that abroad, implies an equi-proportionate
depreciation of the currency. Thus

ge  gP – gP* (1.8)

where g is the rate of change of the respective variable denoted by the subscript (Cassel,
1916, p. 62; Balassa, 1964, p. 584; Krugman, 1978, p. 398; Krueger, 1983, p. 18;
Dornbusch, 1988, p. 267).
The PPP theory has prevailed as an explanation of exchange rate variations, so most
critics focus their attention on it (Officer, 1976, 1980; Isard, 1978, 1995; Krueger,
1978; Dornbusch, 1988).
The PPP theory has been subject to a number of criticisms from the beginning. Yet,
it has not been criticised as a theoretical statement, but rather as an empirical proposi-
tion. Its assumptions—the ‘Law of One Price’ and that all commodities are homo-
geneous, so that their prices are equalised across countries, instantaneously and
without a cost—cannot hold at all times and places. Identical goods baskets and iden-
tical price weights for each basket are other assumptions that are not realistic either
(Dornbusch, 1988, pp. 267–68). Another closely related line of criticism is that PPP
includes traded and non-traded goods in the same goods basket (Officer, 1976, p. 19).
In the relative version of the PPP theory, the very type of price index to be utilised
has been a subject of debate. So, the relative version of PPP implies, in fact, various
different theories depending on the indicator being used: product-price (GDP price
indices), cost of living (consumer or wholesale price indices), or cost-parity (unit
factor costs or unit labour costs).
One important criticism is that, since (short- or long-term) capital movements are
not included as determinants of the real exchange rate in PPP models, the existence of
deviations of the nominal exchange rate from PPP are predictable, given that these
capital flows do influence the exchange rate (Officer, 1976, p. 16). Another important
critique is that the chain of causation, implicit in the PPP theory, runs from relative
prices to exchange rates, whereas there is also a chain of causation running from
exchange rates to prices (Officer, 1976, p. 17; Dornbusch, 1988, p. 268). At best there
seems to be a problem of ‘simultaneity’ (Krugman, 1978).
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68 P. RUIZ-NÁPOLES

Most of the empirical studies on PPP, for various periods and countries, show the
low predictive capacity of this theory regarding exchange rate changes over time, and
the existence of persistent deviations (Officer, 1980; Frenkel, 1981; De Grawe,
Janssens and Leilaert, 1985; Levitch, 1985, p. 1002; Dornbusch, 1988, pp. 276–78;
Froot and Rogoff, 1995; Engel, 2000). While there has been debate as to the nature
and origin of these deviations, for some authors these deviations are persistent and sys-
tematic, and have been associated with structural changes, or changes in productivity,
in the economy under consideration (Officer, 1980; Aglietta and Oudiz, 1984).
This shows that according to some authors, the PPP theory is not, in fact, a theory
of exchange rate determination (Levitch, 1985, p. 1001). What most empirical models
based on PPP theory test is a definition of the real exchange rate. If the theory is cor-
rect, then in the long run the nominal exchange rate should converge to the real
exchange rate, as defined by the PPP theory. So empirical models test the extent to
which this is true, testing in reality market efficiency in adjusting one exchange rate to
the other, under assumed free market and perfect competition conditions across coun-
tries (Levitch, 1985, pp. 999–1002). The time it takes for these two exchange rates
(nominal and real) to converge has also been a matter of discussion (see Abuaf and
Jorion, 1990; Rogoff, 1996; Engel, 2000; Imbs et al., 2003). In sum, the PPP debate
has been centred on issues related to the measurement accuracy of PPP, the causes
that determine the exchange rate deviations from PPP, or measuring the time required
for exchange rate and PPP convergence.
In practice, monetary authorities of various countries have been using price indexes,
i.e., PPP, to estimate their respective real exchange rate, with more or less complex
systems of weights for foreign countries’ prices and currencies (International Monetary
Fund, 1985). In some cases this measure is also being utilised as an indicator for
exchange rate policy.1

II. COST-PARITY APPROACHES

As we have seen, the PPP theory, both in its strong and weak versions, involves the
use of price indexes that, while expressing the effects of supply and demand conditions
in general, do not necessarily reflect the competitiveness of the economy but rather the
general price level. The cost structure would in this case be more revealing. In fact,
one version of PPP is not a price-parity theory but a cost-parity theory. It considers a
ratio of costs (unit factor costs), rather than a ratio of prices, between countries to be
the correct measure of a country’s relative competitiveness and more representative of
long-run prices (see Officer, 1976, p. 10). This early cost-parity concept could not,
however, be employed in a quantitative fashion because unit factor costs are impos-
sible to calculate due to unavailability of data.

1
When the exchange rate is fixed or managed by monetary authorities based on real exchange rates as
defined in PPP, then in the long run there seems to be a high correlation between real and nominal exchange
rates movements over time, which is, of course, spurious.
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PURCHASING POWER PARITY THEORY 69

Houthakker (1962) presented an alternative cost-parity theory: relative unit labour

costs. But to consider cost-parity instead of price-parity within the neo-classical
general equilibrium theoretical framework required some discussion. Thus, motivated
by Houthakker’s ideas, Samuelson (1964) formally considered relative unit labour
costs as determinant of the real exchange rate, in the equation:

w · al
e (2.1)
w* · al*

where e  exchange rate, w  the average wage rate, al  average quantity of labour
per unit of output, for the home country; variables with (*) refer to the foreign country.
Samuelson criticised two crucial aspects of this theory; he concludes that equality
between the exchange rate and relative unit labour costs is superficial. On the one
hand, in addition to labour costs, tastes and demands need to be taken into account in
order to determine relative prices. On the other, nominal exchange rates can also fluc-
tuate with capital movements and gold flows (Samuelson, 1964, p. 146). These points
were also directed at criticising Houthakker’s belief that this measure of the real
exchange rate is the equilibrium rate; that is, the one that produces foreign trade equilib-
rium (Houthakker, 1962; Samuelson, 1964). Bela Balassa also rejected Houthakker’s
unit labour cost approach to estimate the real exchange rate, but on statistical grounds
(Balassa, 1964).
Despite these theoretical and practical considerations about the unit labour cost
approach, some authors and even the International Monetary Fund have been using
relative labour costs as equivalent to real exchange rates without much discussion
(Krugman, 1992, p. 23, Zanello and Desruelle, 1997).1 In fact the IMF calls these
rates the ‘Real Effective Exchange Rates’. And there have even been authors who
defend the unit labour cost approach theoretically within the neo-classical tradition
(Officer, 1974).
Outside this neo-classical general equilibrium framework, there are some authors
related to the Ricardo and Marx labour theory of value tradition, who consider relative
unit labour costs in manufacturing to be either a measure of relative international
competitiveness (Capdeville and Alvarez, 1981; Dosi, Pavitt and Soete, 1990), or the
main determinant of real exchange rates (Shaikh, 1991), or the real exchange rate itself
(Aglietta and Oudiz, 1984).
Empirical tests using new econometrics techniques strongly support that unit labour
costs in manufacturing are the main determinant of real exchange rates (see Shaikh

1
Zanello and Desruelle (1997) calculate relative Unit Labour Costs (ULC) in manufacturing. These
latter are preferred, the authors say, because,
They capture cost developments in an important sector exposed to international competition. . .[and]. . .by
construction they bring into focus the largest component of non-traded costs and of value added, thus
proxying for significant developments in total variable costs. . . . Since capital goods are traded internation-
ally and financial market integration tends to equalize real long term interest rates, the emphasis on labor
costs to asses international competitiveness seems warranted (Zanello and Desruelle, 1997, p. 6).
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70 P. RUIZ-NÁPOLES

and Antonopoulos, 1998; Ruiz-Napoles, 2001). In these empirical tests, causality is

proved to run from unit labour costs to exchange rates (see Ruiz-Napoles, 2001).

III. RELATIVE PRICES AND LABOUR COSTS

If we recall PPP equations (1.1) or (1.2), it is obvious that the nominal exchange rate e
could be equal to the ratio of local to foreign prices if the local foreign exchange mar-
ket forces, supply and demand, are determined only by the exports and imports of
goods and services, respectively. What this means, in other words, is that there are no
credit or other capital flows in foreign currency between the foreign and the home
country. This was the usual assumption in the Walras’ general equilibrium model, of
the type Ohlin assumed for his international trade theorem. Consequently, there must
be one exchange rate that allows exports and imports to be equal, i.e., a trade balance
(see Ohlin, 1933, p. 12). But trade in the real world includes capital movements and
credit between countries, so the exchange rate—which is itself a price—is also influ-
enced in the market by capital flows of various types. Under a flexible exchange rate
regime, deviations of the nominal exchange rate from the real exchange rate—that is
PPP—are to be expected at any moment in countries with developed and open finan-
cial markets. In determining these deviations, capital flows play an important role.1
Thus, any model predicting nominal exchange rate movements must include differ-
ences between local and foreign interest rates, assuming a relation between capital
flows and interest rates. Still, the ratio of prices of tradable goods between the home
country and the rest of the world plays an important part in determining nominal
exchange rate movements in the short run, if the economy is small and open.
On the other hand, Ohlin’s international trade theorem is based on the idea that
relative costs determine general equilibrium relative prices (Ohlin, 1933, p. 12). This
idea depends on various assumptions about similarities between countries with respect
to tastes, demand, income distribution and availability of technology, all of which are
highly questionable. But as we have seen, it is precisely with respect to real exchange
rates that many authors have stressed the importance of costs, in particular labour
costs, as the determining forces, based mostly on empirical evidence.
In that respect, we don’t see much difference between Ricardo’s concept of direct
labour costs and the unit labour costs calculated by the IMF methodology (see
Zanello and Desruelle, 1997),2 except for the national income accounts terminology
that of course was not used by Ricardo. The real difference is theoretical: while for
Ricardo labour costs regulate prices, for the neo-classical general equilibrium tradition
prices are also determined by other forces, especially by demand forces.

1
The whole set of interest rate parity theories are based on the assumption of free capital mobility between
countries, of course linked to PPP theory (see Frankel, 1993).
2
The formula for calculation contains a complex of weights for foreign countries and currencies, but the
important estimation of ULC comes down to ‘the ratio of hourly compensation in manufacturing to
measured labour productivity in that sector. The latter is obtained by dividing sectoral gross value added by
the product of employment and average hours worked per person’ (Zanello and Desruelle, 1997, p. 11).
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PURCHASING POWER PARITY THEORY 71

Of the three main theories of price determination (Semmler, 1984), the classical
theory, based on the labour-theory of value, developed mainly by Ricardo and Marx,
deserves to be considered, especially since labour costs have proven to be the deter-
mining forces of real exchange rates.

IV. RICARDO’S THEORY OF RELATIVE PRICES AND THE

LABOUR THEORY OF VALUE
For Ricardo, value regulates price; that is, the exchange value of a commodity regu-
lates its relative price. In turn, what regulates the exchange value of commodities is the
quantity of labour embodied in them; that is, the quantities of direct and indirect
labour bestowed in their production (Ricardo, 1821, pp. 6–7).
The amount of labour required for the production of any given commodity is deter-
mined by the production technique utilised. Therefore, when simple techniques are
considered, the relative value is independent of the distribution of net output between
wages and profits (Ricardo, 1821, p. 16); that is to say, there is a direct relation
between relative value and relative price.
But when the use of mechanised techniques that require a uniform reward for the
use of capital (uniform rate of profit) is considered, the relation between value as
determined by labour and natural price—that is the price rendering a uniform rate of
profit—is altered, and they are not exactly, but approximately, proportional to each
other, the difference between the two being determined by the proportion of fixed to
total capital among the various activities (Ricardo, 1821, p. 23).
In this case any change in the proportion of profit to wages in any given line of pro-
duction may affect the price of the product. But this, according to Ricardo, is just a
minor cause of variation, the main source being the quantity of labour bestowed in
production (Ricardo, 1821, pp. 22–3).
Within the context of a model in which commodities produced are also considered
as inputs, together with labour, Sraffa tried to find a mechanism for price determina-
tion, alternative to the neo-classical theory of supply and demand. The solution of
such a model consists in finding a set of positive relative natural prices, or prices of
production, that satisfy the input–output relations of the system and provide a definite
distribution of the surplus product between profits and wages, without any specific
assumption regarding marginal returns to factor use and under the condition of uni-
form wage and profit rates (Sraffa, 1960).
Using Pasinetti’s interpretation (Pasinetti, 1977, pp. 71–121), we can write the
price system in matrix notation as:

pA (1  )  aw  p (4.1)

where p  row vector of relative prices, A  matrix of inter-industry input coeffi-

cients, a  row vector of labour inputs, w  wage rate (scalar) and   rate of profit
(scalar).
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72 P. RUIZ-NÁPOLES

Considering an economy of n – 1 branches of production each producing a particu-

lar commodity, we have n – 1 equations and n  1 unknowns: n – 1 prices, w and .
The solution to this system requires these extra three variables outside the system to
be determined. One of the prices can be set equal to unity and becomes the numéraire.
Given the unique inverse relationship between the wage rate and the rate of profit,
the problem is reduced to a choice of one or two in order to close the system.
A particular case is when the rate of profit is zero,   0, and equation (4.1)
becomes:
pA  aw  p
Rearranging we have:
p  a (I – A)–1 w (4.2)
If we make the wage rate equal to one, w  1, we have:
p  a (I – A)–1 (4.3)
–1
where (I – A) is a non-negative matrix representing total input requirements (direct
and indirect) to produce a final product.
Now, defining
v  a (I – A)–1 (4.4)
where v is the vector of vertically integrated labour coefficients, or direct and indirect
labour requirements.
We can see that when the rate of profit is equal to zero, equation (4.2) tells us that
relative prices are proportional to relative physical quantities of embodied labour; and
if the wage rate is defined as the numéraire, these two vectors are identical—equations
(4.3) and (4.4)—thus confirming one of the Ricardian postulates enunciated above.
Another interesting solution consists in setting the wage rate equal to zero, w  0,
in which case equation (4.1) becomes:
p A (1  )  p (4.5)
or
p [I—(1 )A]  0 (4.6)
where   maximum rate of profit.
The problem of the difference between values, as determined by embodied labour
and natural prices, can be seen in this system by noting that equation (4.3) is not pro-
portional to equation (4.5). Relative natural prices are determined by both technical
conditions and the rate of profit; as the rate of profit varies, so do the prices of all com-
modities, but in different proportions, as Ricardo had already noticed, so that while
relative values might be constant, relative prices might be changing.
According to Pasinetti, Ricardo adopted two alternative solutions to this problem
(Pasinetti, 1977, p. 79). One of them was to assume, for analytical purposes, that the
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PURCHASING POWER PARITY THEORY 73

ratio of means of production to direct labour inputs was uniform throughout the econ-
omy so that equation (4.3) would coincide with equation (4.4). It implies:
a (I – A)–1 [I—(1)A]  0
or
v [I – (1  )A]  0 (4.7)
This equation can be satisfied if v is the left eigenvector of matrix A, which can be
denoted by v*; the associated labour coefficient vector being denoted by a*. Thus, we
have:
a*  v*(I – A)
a*  v*– v*A
Now, given that v* is the eigenvector of A:
a*  v* – * v*
where *  maximum eigenvalue of matrix A. So, we have:
a*  (1 – *) v*
a*  [ / (1  )] v* (4.8)
* *
It follows that a , being proportional to v , also becomes an eigenvector of matrix A.
The conclusion is that a necessary and sufficient condition for prices to be propor-
tional to values is that the vector of vertically integrated labour coefficients is a left
eigenvector of A.
According to equation (4.8), total direct and indirect labour requirements for each
commodity are in a given proportion to direct labour requirements, and this is the
same for all commodities, as assumed above.
This solution confirms the conditions for relative (natural) prices to be exactly pro-
portional to relative values. But the assumption that all branches have the same ratio
of means of production to labour, though useful for some analytical purposes, is not
only unrealistic but also contradictory with the nature of the capitalist system. Hence,
it has to be removed when dealing with a long run equilibrium price system. As this is
done, natural prices differ from values, since the former are determined by the rate of
profit and the relative labour requirements, while the latter are determined by labour
requirements alone.
Then the second solution Ricardo followed was to assume that price-value devia-
tions were ‘slight’ (see Ricardo, 1821, p. 22). In order to see to what extent Ricardo
was right in this assumption, one has to look at the nature and the magnitude of these
price-value deviations.
We can posit the problem in the following terms: when   0, relative prices and
relative values are exactly proportional, but if  0 and the capital–labour ratio dif-
fers among branches of production, relative prices are not exactly proportional to rela-
tive values.
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74 P. RUIZ-NÁPOLES

It follows that prices vary with the rate of profit, i.e., dp/d 0 in absolute terms
for any particular commodity. But the calculation of the rate of profit, in turn, depends
on prices. Then, price-value deviations are seen as a very complex phenomenon with
two main causes: first, a positive uniform rate of profit with varying capital–labour
ratios and second, the interacting effect of price–profit rate calculations.
These two effects are analysed by Pasinetti (1977) with the following results: the
capital-intensity effect has a definite direction; it is positive for commodities produced
with a capital–labour ratio higher than the corresponding ratio for the commodity used
as the numéraire, and it is negative for commodities produced with a lower capital–
labour ratio. The second, the so-called price effect, cannot be predicted either in mag-
nitude or in direction (Pasinetti, 1977, pp. 83–4).
Some empirical studies suggest, however, that overall price-value deviations are
slight and predictable in direction. In any case, price-value deviations are second order
variations both theoretically and empirically (Shaikh, 1998).
Ricardo seems to have been aware of the two effects and also of their relative import-
ance. Hence, he postulated that the overall effect in actual price-value differences
could not be expected to be greater than 7 per cent, so he emphasised the strong
relation between value and embodied labour as the decisive one (see Ricardo, 1821,
pp. 22–3).1

V. LABOUR VALUE AND RELATIVE ADVANTAGES

Before we proceed any further it is important to analyse Ricardo’s statement that
The same rule that regulates the relative value of commodities in one country does not regulate
the relative value of the commodities exchanged between two or more countries (Ricardo, 1821,
p.81),

in connection to our proposition that relative unit labour costs between countries
determine their real exchange rate.
Ricardo argued that the amount of labour required for the production of any given
commodity relative to another commodity in one country, compared with the same
ratio in some other country with which free trade could be established, does not deter-
mine its final international price, due to the relative immobility of labour and capital
between countries, which prevented the establishing of uniform rates of profit and
wages across countries. In contrast, he proposed a principle according to which a
country should specialise in producing and exporting those goods for which it has the
greatest relative advantage and import those other goods for which it has the least
relative advantage, because by doing so it could get these goods cheaper than by pro-
ducing them. It is from this principle that the neo-classical theory of comparative costs
was derived (see Ohlin, 1933). But unlike neo-classical theoreticians, Ricardo never
took for granted that the same technology was utilised in all countries engaged in trade.
1
This is why Samuelson makes fun of Ricardo, with his remark that Ricardo has a 93 per cent theory of
value (Samuelson, 1971, p. 405).
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PURCHASING POWER PARITY THEORY 75

On the contrary, he stressed that having different production techniques between

countries was one of the causes of their difference in relative values; therefore, a change
in the conditions of production in one of the trading countries might invert its relative
advantage (Ricardo, 1821, p. 84).
There have been various interpretations of Ricardo’s aforementioned statement.
One is that relative labour values do not determine relative prices between countries
but relative advantages do. So when expressed in terms of opportunity costs instead of
values, these relative advantages become comparative costs and, together with recipro-
cal demand, they do determine international prices. This interpretation is the usual
one in neo-classical theory.
Another interpretation is that of Steedman and Metcalfe:
Ricardo could not have shown that profit maximizing competition under free trade would result
in mutual gain to the trading countries had he not identified no-trade price ratios with embodied
labour ratios (Steedman and Metcalfe, 1979, p. 105).

Still another is the interpretation of De Vivo:

The fact that it would be convenient for the two countries to specialize in consequence of a dif-
ference in the comparative costs of producing the two commodities does not by itself ensure that
the specialization will actually take place in the two (decentralized) economies. Nor that these
relative advantages would finally determine the price ratio between countries of any given com-
modity (De Vivo, 1987, p. 194).

A point that might clarify this question is that when Ricardo referred to relative
prices determined within one country, he means the relative value of a commodity
measured in labour time, assuming equal profitability and equal wage rates across
sectors. These relative ‘natural’ prices cannot be obtained across countries because
equal profitability and equal wage rates between countries cannot be assumed. So, for
Ricardo, the formation of natural prices is internal to each country. But this does not
mean that the absolute prices for the same commodity in different countries cannot be
compared with one another if measured in money terms. And this is what he does by
introducing money prices in the analysis of foreign trade. In Ricardo’s example, before
trade, individual money prices between countries are exactly proportional to their
corresponding values. So the price ratio between countries show only absolute advan-
tages, favouring trade in only one direction. Ricardo then applies the Quantity Theory
of Money, which dictates that all money prices in one country vary according to the
amount of money in circulation, so the mechanism through which comparative advan-
tages could show up in money prices is the price-specie-flow mechanism, first estab-
lished by Hume (see Ricardo, 1821, p. 86; Roll, 1974, p. 194; Shaikh, 1980, pp.
212–4; De Vivo, 1987).
But then it is the price of gold in each country which, in fact, is not determined by
the amount of labour required in its production but by its flow between countries. In
other words, its market price may differ from its ‘natural’ price indefinitely (De Vivo,
1987, p. 195), while pre-trade relative values within each country remain the same,
unless there is an improvement in production techniques (Ricardo, 1821, p. 84). And
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76 P. RUIZ-NÁPOLES

in fact since the Quantity Theory of Money assumes that all prices vary in any one
country at the same rate, the structure of relative prices must remain the same before
and after trade unless, of course, specialisation—if it occurs—brings about some
improvements in productivity.
So, unlike Emmanuel (1972), we are not trying to establish relative natural prices
between countries for each commodity, precisely because we are considering that the
conditions of production, profit and wage rates cannot be assumed to be the same
between any pair of countries, even today when the mobility of capital and labour is
relatively higher than in Ricardo’s time, especially in some trading areas. So we main-
tain that Ricardo’s original statement is correct.

VI. UNIT LABOUR COST BASED ON VERTICALLY

INTEGRATED LABOUR
If we apply Ricardo’s theory of price determination, as developed by Pasinetti (see
below), we cannot assume that the profit rate is zero; neither are we estimating natural
prices with a positive uniform profit rate or uniform capital–labour ratios across sec-
tors. And according to what we have just seen, we are neither estimating natural prices
between countries as if they were regions within one country.
The proposition is that, by applying this model, we are calculating vertically inte-
grated unit labour costs (VIULC). But according to Ricardo, these average VIULC
will determine average prices in each economy and, therefore, the ratio of the two
countries’ VIULC determines the real exchange rate between their currencies. Con-
sequently, in principle, the real exchange rate determination equation is:
R  vur/vur* (6.1)
where R  real effective exchange rate, vur  real vertically integrated unit labour
costs in the home country, vur*  real vertically integrated unit labour costs in the
foreign country; each variable is measured in its corresponding country’s currency.
Both variables are in real terms, i.e., deflated by the appropriate price index, all with
the same base year to make valid comparisons.
According to Ricardo, labour costs regulate prices. But they are costs, not prices;
that is to say, labour costs act as ‘centres of gravity’ for prices (see Semmler, 1984). In
other words, price variations in the short and medium terms are also explained by
other factors.
Therefore, this real effective exchange rate R must be distinguished from the market
nominal exchange rate e, which is determined, in addition to relative real VIULC, by
two other variables: the flow of foreign capital and the level of output. The inclusion of
the former is amply justified by the arguments above, regarding capital market influ-
ence on nominal exchange rate in the short run. Also, to consider the level of output
as a determining variable is justified by the macroeconomic view that, in an open
economy, aggregate demand affects both the supply and the demand for foreign cur-
rency, via exports and imports.
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PURCHASING POWER PARITY THEORY 77

Thus, assuming free mobility of capital, free trade and a flexible exchange rate
regime we have:
e 
(R, F, Y) (6.2)
where e nominal market exchange rate, R  real effective exchange rate, F  net
inflow of foreign capital and Y  real income. If e and R are expressed as local
currency units per unit of foreign currency, then we expect the sign of the R parameter
to be greater than zero, the F parameter to be negative and the Y parameter could be
either but with a low value.1
In order to estimate each country’s real VIULC we have:
vur  a (I – A)–1 wr (6.3)
where vur  average real vertically integrated unit labour costs (a scalar), a  row vec-
tor of direct labour coefficients, A  technical coefficients matrix, and wr  column
vector of real wages (wages per man). To make the formula operational, the foreign
country’s VIULC in equation (6.1) must be a weighted average of the home country
trading partners’ VIULC.
There have been some interesting theoretical approaches to productivity estimation
with vertically integrated sectors (Dosi et al., 1990; De Juan and Febrero, 2000). In
fact, average overall competitiveness says very little about trade advantages. So, in the
line of sectoral analysis, we can calculate relative VIULC by industry, which will give
us a good indicator of relative competitiveness for each industry.
In matrix notation for each country, we have:
vur  a (I - A)–1 Ŵ (6.4)
where vur  row vector with real VILUC for each industry, and Ŵ  diagonal matrix
of the same order as A, with real wages in the main diagonal and zeros elsewhere.
Thus:
Ŵ  wr · I (6.5)
where wr  column vector of real wages and I  identity matrix.
Each element in vector vur corresponds to vuri, where the subscript i denotes a par-
ticular industry, i  1, 2, 3. . .n, n being the number of industries included in the
matrix A.

CONCLUSIONS
For years empirical studies have questioned the validity of PPP as a theory of exchange
rate determination. Cost-parity indicators, and in particular unit labour costs, have
been more successful in empirical tests across countries. But to accept that relative
1
Some studies have found that this coefficient varies in sign in different periods and in different countries
(see Harberger, 2003, Appendix).
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78 P. RUIZ-NÁPOLES

labour costs determine real exchange rates between countries represents a problem for
the neo-classical general equilibrium price determination tradition, because it implies
that relative labour costs determine relative prices. Therefore, this latter implication is
better dealt with in the context of the classical labour theory of value, originally pre-
sented in the works of Ricardo and Marx but formally presented by Pasinetti. Using
Pasinetti’s model we have developed a theory of real exchange rate determination by
relative real vertically integrated unit labour cost. Also, relative competitiveness by
industry between countries can be measured in the same model.

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doi:10.1093/cpe/bzh004