Research Journal of Finance and Accounting www.iiste.org ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online) Vol.5, No.17, 2014 193 Purchasing Power Parity: Implication with respect to Pakistan and USA Kalsoom Akhtar (Corresponding author) Visiting Lecturer & Research Scholar, Department of Management Sciences, The Islamia University of Bahawalpur, Pakistan E-mail: kalsoom_2010@yahoo.com Mubeen Mujahid MS & Research Scholar, Department of Management Sciences, The Islamia University of Bahawalpur, Pakistan E-mail: malikmubeen.awan@yahoo.com Muhammad Abdullah Zuberi MS & Research Scholar, Department of Management Sciences, The Islamia University of Bahawalpur, Pakistan E-mail: abdullahzuberi1@yahoo.com Muhammad Shazib MS & Research Scholar, Department of Management Sciences, The Islamia University of Bahawalpur, Pakistan E-mail: shazibarif@gmail.com Abstract The basic aim of this paper is theoretical explanation of Purchasing Power Parity and its practical implication in the real world. The researchers tried to explain whether it holds in the real world or not, if not then what are major factors deviating its practical implication from that what the theory says about it. This paper specifically draws the findings how actually exchange rate moves with the domestic and foreign price index. This study is based on the historical prices indexes of two countries Pakistan and USA pertaining the period from 1980 to 2011. So our sample size is two with the number of observations equal to 31. The results of this research expressed the findings that the Exchange rate (Pakistani rupees per dollar ) increases with the increase in the domestic price index, means home currency will depreciate against the foreign currency. These findings are drawn on the basis of beta coefficients obtained from the regression analysis. The research results expressed that PPP holds to some extent which shows that inflation differential has a considerable impact on exchange rate movement but it is not the only factor. Keywords: Relative PPP, Absolute PPP, IRP, Exchange rates, Inflation rate differential. 1. Introduction Purchasing power parity (PPP) is a theory states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. In other words, the exchange rate between two countries should equal the ratio of the price level of these two countries for a fixed basket of goods and services in the economies. When a country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must depreciated in order to return to PPP. Actually, when one country’s inflation rate rises relative to that of another country, decreased exports and increased imports depress the country’s currency. And here PPP theory plays its role and tries to quantify this inflation-exchange rate relationship. Purchasing power parity has two forms, absolute form of PPP and relative form of PPP. Absolute form of PPP or "law of one price" says that similar products in different countries should be equally priced when measured in the same currency. While relative form of PPP considers market imperfections like tariffs, transportation costs imposed on few countries. This form actually meant that rate of price changes should be similar in both countries. For example, if the inflation rate in US is 10% and in UK it is 12%. US people will stop buying the goods from their home country and demand of UK goods will increase by US people. Due to high inflation UK will decrease their demand for US products. In the result of this difference in inflation rate between these two countries, Foreign currency that British pound in this case will be appreciated by two percent (in other words we can say that home currency will be depressed by 2%). The shift in consumption of goods from U.S to U.K and appreciation of pound will continue until price of U.K goods, in the U.S ≥ Price of U.S goods, and in the U.K, price of U.S goods≤ price of U.K goods. Formula for calculating new foreign exchange rate is given as follows: