Formulated by Gustan Cassel in 1920. Theory formulated during period when inflation was very high. The theory puts forward the idea that when currencies are exchanged among nations, their purchasing power is only transferred. This means that a person should be able to buy the same amount of goods in either country , when expressed in either country¶s currency. The theory suggests that the principle determinant of exchange rate is the difference in National Inflation Rates.     

This means , a country where costs and prices are relatively less than another country will find its currency appreciating. The law of one price is usually the basis to interpret this theory. According to this law, after making allowances for tariff and transport costs, the price of goods in one country should not significantly differ from that in another country. P= EP*. Where P is the price of the product in domestic country P* is the price of same product in a foreign country E= domestic currency price of the foreign currency.       

If P and P* can be interpreted as the domestic and foreign price index, representing the respective inflation figures , the exchange rates becomes the ratio of relative price levels in the two countries. An important application of the PPP theory is that the nominal exchange rate must adjust significantly and sufficiently so as to reflect /compensate the underlying inflation difference. Once this happens, the international competitiveness of any country¶s product I the world market shall be maintained.   

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As per PPP theory The real Exchange rate= Nominal exchange rate * Foreign price index/ domestic price index. = 44 *100/110= 40 where 44= exchange rate 100= foreign price index and 110= domestic price index which has increased to 110 due to inflation. The real exchange rate appreciates to 40. 

This adversely affects the exporter¶s ability to compete globally due to the fact that if a US importer pays \$ 1 for a product , the Indian exporter will get Rs 44 , which is the nominal exchange rate, which is worth only Rs 40 because of effect of inflation in India. Thus to maintain the real exchange rate as 44, the nominal exchange rate should depreciate by 10% i.e 48.4 in this example. Then the exporter get the true value of 44 (which is the real exchange rate)    

The essence of this theory is that one must export to a country whose inflation rate is higher than the domestic inflation rate. In the case of imports, one must import from a country whose inflation rate is lower than the domestic country. 

Drawbacks of PPP theory: Doesn¶t take into account actual practice factors such as current account performance, portfolio decisions, interest rates, economic growth and central bank¶s intervention, which have an effect on the variations in exchange rates.  

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Classical Theories of International Trade. The classical theories of international trade1 were suggested by Adam Smith, David Ricardo, J.S. Mill. The basic assumptions of the classical theories are: 2 x 2 x 1 model (implying two countries, two products and single factor of production). Perfect competition in both output and input markets. Homogenous labor Mobility of labor internally and immobility internationally Constant returns to scale Free trade No transportation costs Labor theory of value Full employment of factors of production. 

J.S. Mill has restated the Ricardian theory in terms of comparative advantage or comparative effectiveness of labor in order to examine the question of international value (i.e. the ratios at (i. which goods would exchange for one another). another). Ricardo has taken the given output of each commodity in terms of differing labor costs. costs. Mill on the other hand has assumed a given amount of labor in each country and considered differing output of the two goods due to differing labor efficiency. efficiency.   

According to Mill¶s Doctrine of Reciprocal Demand, the actual ratio at which goods exchange between the two countries will depend on a reciprocal demand. demand. Reciprocal demand means the relative strength and elasticity of demand of two trading countries for each other¶s product in terms of their own product. product. A stable ratio of exchange will be fixed at the point at which the value of imports and exports of each country is in equilibrium. equilibrium.   

Offer Curves
How the Terms of Trade Are Established

Offer Curves are   

all combinations of a country¶s desired exports and imports at different terms of trade also known as reciprocal demand curves (J.S. Mills) measures of willingness to trade

Offer Curves   

Offer curves represent willingness to trade at every possible terms of trade As the relative price of good X rises, Country A becomes willing to export more and import more Offer curves ³bow´ towards the import good axis

Terms of Trade Equilibrium  

The international terms of trade (that is, PX/PY) will be the slope of a line passing through the point where the offer curves cross. This equilibrium point takes into account demand and supply conditions in both countries

Y OCA (PX/PY)E

OCB Y1

X1

X

Y OCA (PX/PY)E

OCB Y1 If these are the terms of trade, country A will desire to export X1 units, and country B will want to import X1 units

X1

X

Y OCA (PX/PY)E

OCB Y1 If these are the terms of trade, country A will desire to import Y1 units, and country B will want to export Y1 units

X1

X

How Do We Know It¶s Equilibrium? 

Any terms of trade other than (PX/PY)E will result in
 excess demand for one good  excess supply for the other 

Therefore relative prices will adjust until (PX/PY)E is reached

Disequilibrium
Y OCA (PX/PY)1

OCB

X

Disequilibrium
Y OCA (PX/PY)1

Y1 Y2

OCB

X

Disequilibrium
Y OCA (PX/PY)1

Y1 Y2

OCB At (PX/PY)1, country A wishes to import Y1 units, but country B is only interested in exporting Y2 units. That is, there is an excess demand for good Y. X

Disequilibrium
Y OCA (PX/PY)1

OCB

X2

X1

X

Disequilibrium
Y OCA (PX/PY)1

OCB At (PX/PY)1, country A wishes to export X1 units, but country B is only interested in importing X2 units. That is, there is an excess supply of good X. X2 X1 X

Disequilibrium  

 

Excess demand for Y causes PY to rise Excess supply of X causes PX to fall Thus, (PX/PY) falls In other words, the terms of trade line gets flatter, moving the countries in the direction of equilibrium

Moving Towards Equilibrium
Y (PX/PY)1 OCA

OCB

X

Disequilibrium 

Terms of trade lines that are flatter than (PX/PY)E, such as

Disequilibrium
Y OCA (PX/PY)2

OCB

X

Disequilibrium 

Terms of trade lines that are flatter than (PX/PY)E will results in
 an excess demand for good X  an excess supply of good Y, and so 



(PX/PY) will rise That is, the terms of trade line will get steeper until (PX/PY)E is reached

Moving Towards Equilibrium
Y OCA (PX/PY)2

OCB

X

A Note on the Terms of Trade   

A country¶s ³terms of trade´ are the price of its exports divided by the price of its imports, so a rising terms of trade is good news In this example, (PX/PY) is country A¶s terms of trade, since A exports good X and imports Y (PY/PX) is country B¶s terms of trade in this example

A Note on the Terms of Trade, continued 

As A¶s terms of trade (PX/PY) improve, B¶s terms of trade (PY/PX) must be deteriorating and vice-versa vice-

Shifts of Offer Curves 

Anything that causes country A¶s willingness to trade to change will shift A¶s offer curve
 increased willingness to trade: OCA shifts right  decreased willingness to trade: OCA shifts left 

These can be caused by
 changes in demand conditions or  changes in supply conditions

Demand Changes in Country A
Y OCA (PX/PY)E

OCB Y1

X1

X

Demand Changes in Country A
Y (PX/PY)E OCA OCA'

OCB

Increased demand for imports by Country A causes a rightward shift of A¶s offer curve X

Demand Changes in Country A
Y (PX/PY)E OCA OCA' (PX/PY)E' OCB

Y2

Volume of trade increases, but A¶s terms of trade go down. B¶s terms of trade improve. X2 X

Demand Changes in A 

Any change that might make A demand more imports leads to a rightward OC shift, and thus
 an increase in trade volume  a decrease in A¶s terms of trade

Demand Changes in Country B
Y OCA (PX/PY)E

OCB Y1

X1

X

Demand Changes in Country B
Y OCA (PX/PY)E OCB' OCB

Increased demand for imports by Country B shifts B¶s OC upward

X

Demand Changes in Country B
Y OCA (PX/PY)E' (PX/PY)E OCB' Y2 OCB

Volume of trade increases, but Country B¶s terms of trade decrease (and A¶s terms of trade improve). X2 X

Other Demand Changes   

Any decrease in a country¶s willingness to trade will shift its OC leftward or downward An example is when a country imposes an import tariff Tariffs therefore lead to decreased trade volume, but improve the imposing country¶s terms of trade

Imposition of Tariff by Country A OC
Y
A

(PX/PY)E

OCB Y1

X1

X

Imposition of Tariff by Country A OC OC
Y
' A A

(PX/PY)E

OCB Y1

X1

X

Imposition of Tariff by Country A /P ) (P OC OC
Y
' A A X Y E'

(PX/PY)E OCB Y2

X2

X

Imposition of Tariff by Country A /P ) (P OC OC
Y
' A A X Y E'

(PX/PY)E OCB Y2 By imposing a tariff, Country A decreases trade volume, and improves its terms of trade (but B¶s terms of trade deteriorate) X2 X

Supply Changes  

Changes in supply conditions will also shift a country¶s offer curves around Examples include
 productivity changes  discovery of new resources