Something like the purchasing power parity theory has existed throughout the modern history of international economics. The theory keeps resurfacing whenever exchange rates have become more variable as a result of wars or other events.

Sometimes the hypothesis is used as a way of describing how a nation’s general price level must change to reestablish some desired exchange rate, given the level and trend in foreign prices. At other times it is used to guess at what the equilibrium exchange rate will be, given recent trends in prices within and outside the country. Both of these interpretations crept into the British

“bullionist–antibullionist” debate during and after the Napoleonic Wars, when the issue was why Britain had been driven by the wars to dislodge the pound sterling from its fixed exchange rates and gold backing, and what could be done about it.

The PPP hypothesis came into its own in the 1920s, when Gustav Cassel and others directed it at the issue of how much European countries would have to change their official exchange rates or their domestic price levels, given that World War I had driven the exchange rates off their prewar par values and had brought varying percentages of price inflation to different countries. For instance, PPP was a rough guide to the mistake made by Britain in returning to the prewar gold parity for the pound sterling in 1925 despite greater price inflation in Britain than in Britain’s trading partners.

With the restoration of fixed exchange rates following World War II, the PPP hypothesis again faded from prominence, ostensibly because its defects had been demonstrated, but mainly because the issue it raised seemed less compelling as long as exchange rates were expected to stay fixed.

After the resumption of widespread floating of exchange rates in the early 1970s, the hypothesis has been revived once again. It is now used as a standard for examining whether countries’

currencies are undervalued or overvalued at their market exchange rates.

DISCUSSION QUESTION Why was the PPP hypothesis less interesting when the major countries had fixed exchange rates and similar product-price inflation rates?