The rupee-dollar exchange rate is Rs 40 per dollar. Over some years the price level in India, measured by a price index such as the GDP deflator, rises from 100 to 120, while prices in the US do not change. According to the purchasing power parity theory, the exchange rate will become:
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → Rs 48 per dollar
Given:
Old exchange rate = Rs 40 per dollar
Price level in India: 100 rises to 120
Price level in the US: unchanged
By purchasing power parity, the exchange rate moves with the difference in price levels. Indian prices rise by 20 per cent, so the rupee price of a dollar also rises by 20 per cent.
\( \displaystyle \text{New rate} = 40 \times \frac{120}{100} \)
\( = \text{Rs } 48 \text{ per dollar} \)
The price index here plays the role of the GDP deflator, a measure of the price level. This question uses National Income Accounting and Open Economy Macroeconomics together.
NCERT (2026-27): “Exchange Rates in the Long Run … Over the long run, therefore, exchange rates between any two national currencies adjust to reflect differences in the price levels in the two countries.” “EXAMPLE … Next, we suppose that prices in India rise by 20 per cent while prices in the US rise by 50 per cent. Indian shirts would now cost Rs 480 per shirt while American shirts cost $12 per shirt. For these two prices to be equivalent, $12 must be worth Rs 480, or one dollar must be worth Rs 40. The dollar, therefore, has depreciated.” |