Question

a) Write down the equation for Absolute Purchasing Power Parity

b) Consider the information given in the following Table, and fill in cells (i) – (ix).

c) Are the official exchange rates in India undervalued or overvalued?

d) Evaluate if real exchange rate has appreciated or depreciated in 2012 and 2015, estimate the rate of such appreciation or depreciation, and indicate them in cells (x)-(xiii).

e) What are the nominal exchange rates that would maintain Absolute PPP.   Indicate them in cells (xiv) - (xvi).

	2010		2012		2015
Country	India	USA	India	USA	India	USA
Nominal Ex Rate	i    $/Rs.	46 Rs/$	ii $/Rs.	53 Rs/$	iii $/Rs.	64 Rs/$
Price Index – Local Currency	4600	100	5474	105	6762	108
Real Exchange Rate	iv US Goods/Indian Good	v. Indian Goods/US Good	vi US Goods/Indian Good	vii Indian Goods/US Good	viii US Goods/Indian Good	ix Indian Goods/US Good
Rate of App/Dep of Real Ex Rate			x	xi	xii	xiii
Nominal Exchange Rate as per PPP		xiv		xv		xvi

f) What is the equation for Relative PPP?

g) What are Indian and US inflation rates in 2012 and 2015 relative to 2010?

h) Evaluate if the Relative PPP is held in 2012 and 2015 between India and the USA.

Answer 1

a]

P_a = P_b x E, where E, P_a, and P_b indicate the exchange rate, the price level in country 'a', and the price level in country 'b'.

b]

i] 1/46 = 0.021 ii] 1/53 = 0.018 iii] 1/64 = 0.015

RER = (Nominal exchange rate x Price of the foreign basket) / (Price of the domestic basket)

iv] RER = (46 x 100) / 4600 = 1            v] RER = (4600 x 0.021)/100 = 0.966

vi] RER = (53 x 105) / 5474 = 1.01                  vii] RER = (5474 x 0.018) / 105 = 0.9384

viii] RER = (64x 108) / 6762 = 1.022                ix] RER = (6762 x 0.015) / 108 = 0.9391

c] Since Indias real exchange rate is a bit more than one in 2012 and 2013 it is overvalued in these years.

d] x] (1.01-1)x 100 /1 = 1% xi] (0.9384-0.966)x 100 /0.966 = -2.8% Similarly ,xii] 1.1% xiii] -0.7%

e] xiv] 46 xv] 5474/105=52.133 xvi] 6762/108 = 62.611

f]

The relative PPP indicates that the changes in the dollar–British pound exchange rate (eg, any two countries can be taken) reflect the changes in the ratio of the U.S. and U.K. price levels (P_USand P_UK):

g]

Inflation Rate = ((T2 - T1) / T1) x 100

T1 = Price for the first time period (or the starting number)
T2 = Price for second time period (or the ending number)

India: 2012 = 19%; 2015 =47%

USA: 2012 = 5%; 2015= 8%