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

1920 s, 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 infla-

tion to different countries. For instance, PPP was a

rough guide to the mistake made by Britain in return-

ing 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 follow-

ing 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 1970 s, the hypothesis

has been revived once again. It is now used as a

standard for examining whether countries' curren-

cies are undervalued or overvalued at their market

exchange rates.

Why was the PPP hypothesis less interesting when

the major countries had fixed exchange rates and

similar product-price inflation rates?