Exchange Rates and Purchasing Power Parity

By PARTHIPAN & ARUL MARKAS

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Introduction
Exchange rates matter in many different ways to many different constituencies in the world economy Much of this section on international finance will be directly or indirectly concerned with exchange rates

The Nominal Exchange Rate

Relative price of two currencies Often expressed as number of units of local or home currency
required to buy a unit of foreign currency

We will usually view india(Rs) as our home country and United States (dollar) as our foreign country Nominal or currency exchange rate (e) is local currency RS e foreign currency dollar

If e increases the value of the Rs(home currency) falls If e decreases the value of the Rs(home currency) rises e and the value of the Rs are inversely related
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e is often graphed as its inverse which is equal to the value of the Rs

The Real Exchange Rate

Measures the rate at which two countries goods trade against each other Makes use of the price levels in the two countries under consideration PINDIAoverall price level in India (the home

country) PUSoverall price level in the United States (the foreign country)
PUS re e Rs P
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The Real Exchange Rate

Suppose that the price level in the United States rises Takes more Indian goods to purchase US goods Represents a fall in the real value of the Rupees Suppose that the price level in India rises Takes fewer Indian goods to purchase US goods Represents a rise in the real value of the Rupees Suppose that the nominal exchange rate increases Takes more Indian Rupees to buy a US dollar and, therefore, more
Indian goods to buy US goods Represents a fall in the real value of the Rupees

Real exchange rates affected by both nominal exchange rates and price levels
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Exchange Rates and Trade Flows

Changes in e have an impact on trade flows Consider the case of India imports and exports World prices (PW) are typically in US dollar terms India prices (PRs) are in Rs terms
Relationship between the Rupees and world prices of India
import (Z) goods can be expressed as

PZRs e PZW

PZW is in dollar terms Rs Multiplying it by e gives us PZ in Rupees terms

Exchange Rates and Trade Flows

Suppose e were to increase (the value of the Rupees falls)

If e increases the value of the Rs(home currency) falls

Movement down the scale in increases the Rupees price

Suppose e were to decrease (the value of the Rupees rises)

If e decreases the value of the Rs(home currency) rises

of the imported good in India Import demand consequently decreases

Movement up the scale in decreases the Rupees price of

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the imported good in India Import demand consequently increases

The Value of the Rupees and Indias Exports

Value of Rupees and Indias Exports

1/e

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Exchange Rates and Trade Flows

Relationship between the Rupees and dollar prices of india exported (E) goods can be expressed as Rs W PE e PE Suppose e were to increase (the value of the Rupees falls) Movement down the scale in increases the Rupees price

of the export good in india Export supply in india consequently increases Indian firms now have more of an incentive in Rupees terms to
export

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Exchange Rates and Trade Flows

Suppose e were to decrease (the value of the Rupees rises) Movement up the inverse scale in decreases the
Rupees price of exports in india Export supply consequently decrease

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