Question

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Question C5

According to purchasing-power parity, when the local central bank reduces money supply, what is the expected change in nominal exchange rates?

Answer 1

Purchasing power parity is a theory which is used while finding the rate of exchange between two countries through paper currency standard by the ratio of their purchasing power.

Now the effect of reducing the money supply would be like, when the money supply is reduced the aggregate demand is also reduced and the prices of commodities will go down.

As per the calculation of purchasing power parity between two countries, we would find the ratio of purchasing power of currency

For example,

Finding the exchange rate of India and America through PPP(purchasing power parity)

In India rice per quintal is rupees 1000

in America rice per quntal is $50

so

    R = 50/1000 = 1/25

Hence, Re 1 = 1/25$

Now applying the situation when prices of commodities has reduces so the price of rice per quintal is let be Re.750

so
    R = 50/750 = 1/15           (R= rate of exchange)

Hence, Re.1 = 1/15$

that means the value of Indian rupee has increased.

So, the reduction in money supply will indirectly increase the exchange value of given country.