INDIA AND THE WORLD ECONOMYLECTURE 10Concluding discussions on Exchange RatesAndIndia’s Structural Change, Industrial Policy and International Trade
Purchasing Power Parity- basic definition•A purchasing power parity between two countries, A and B, is the ratio of the number of units of country A’s currency needed to purchase in country A the same quantity of a specific good or service as one unit of country B’s currency will purchase in country B. •PPPs can be expressed in the currency of either of the countries. •In practice, they are usually computed among large numbers of countries and expressed in terms of a single currency, with the U.S. dollar (US$) most commonly used as the base or “numeraire” currency.•In textbook economics, it is taken that If absolute PPP holds then exchange rate equates the national price levels in two countries. Or, in other words, Purchasing power parity implies that EINR/US$= PIndia/PUSAHowever, in real life absolute PPP hardly holds
Purchasing Power Parity does not explain the present exchange rate levels- Why?•The basket to measure price levels may be vastly different from country to country•Goods cannot be transferred across countries freely; shipping and other transactions costs can turn out to be much different from the initial conditions; •Trade and other restrictions often exist, distorting prices. •There is a large non-traded sector•Often financial flows dictate the level of exchange rate•In most cases, there is central bank intervention in the foreign exchange markets•Therefore, the actual exchange rates are usually overvalued or undervalued in terms of the purchasing power parity.
Purchasing Power Parity (cont.)•Relative PPP: changesin exchange rates equal changesin prices (inflation) between two periods:(E$/€,t –E$/€, t –1)/E$/€, t–1= US, t –EU, t where t = inflation rate from period t –1to tRelative PPP suggests that percentage change in the exchange rate between two countries over any period equals the difference between the percentage change in the national price level.Relative PPP is more important from a policy perspective because different governments use vastly different baskets for measuring price levels and consequently across country Absolute PPP measures make little sense6Therefore, if India is persistently experiencing higher inflation than its trade partners, it can be expected that there will be a depreciation of Indian currency
Inflation rate, average consumer prices Annual percent change+Therefore, if we bring our interest and price level parity conditions together….
What happens when a currency depreciates?•Depreciation is a decrease in the value of a currency relative to another currency. •A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency.