Gustav Cassel, a Swedish economist, developed the theory of exchange rates known as purchasing power parity in a series of post-World War I memoranda for the League of Nations. The basic concept can be made clear with an example. If US$4 buys one bushel of wheat in the United States, and if 120 Japanese yen exchange for US$1, then the price of a bushel of wheat in Japan should be 480 yen (4 × 120). In other words, there should be parity between the purchasing power of one U.S. dollar in the United States and the purchasing power of its exchange value in Japan.
Cassel believed that if an exchange rate was not at parity, it was in disequilibrium and that either the exchange rate or the purchasing power would adjust until parity was achieved. The reason is arbitrage. If wheat sold for four dollars in the United States and for six hundred yen in Japan, then arbitragers could buy wheat in the United States and sell it in Japan and would do so until the price differential was eliminated.
Economists now realize that purchasing power parity would hold if all of a country’s goods were traded internationally. But most goods are not. If a hamburger cost two dollars in the United States and three dollars in Japan, arbitragers would not buy hamburgers in the United States and resell them in Japan. Transportation costs and storage costs would more than wipe out the gain from arbitrage. Nevertheless, economists still take seriously the concept of purchasing power parity. They often use it as a starting point for predicting exchange rate changes. If, for example, Israel’s annual inflation rate is 20 percent and the U.S. inflation rate is 4 percent, chances are high that the Israeli shekel will lose value in exchange for the U.S. dollar.
Cassel was a professor of economics at the University of Stockholm from 1903 to 1936. His dying words were, “A world currency!”