The rupee-dollar exchange rate is Rs 50 per dollar, and the purchasing power parity theory holds. Over some years, prices in India rise by 50 per cent while prices in the US rise by 25 per cent. What does the theory predict?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → Rs 60 per dollar; the rupee depreciates
Given:
Exchange rate now = Rs 50 per dollar
Rise in Indian prices = 50 per cent
Rise in US prices = 25 per cent
By purchasing power parity, the same good must cost the same in both countries. Take a good worth $1 = Rs 50.
New Indian price = 50 × 1.5 = Rs 75
New US price = 1 × 1.25 = $1.25
\( \displaystyle \text{Exchange rate} = \frac{75}{1.25} = \) Rs 60 per dollar
More rupees are now needed for a dollar, so the rupee depreciates.
Option (4) Rs 75 per dollar; the rupee depreciates — Rs 75 ignores the rise in US prices.
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 If a shirt costs $8 in the US and Rs 400 in India, the rupee-dollar exchange rate should be Rs 50. To see why, at any rate higher than Rs 50, say Rs 60, it costs Rs 480 per shirt in the US but only Rs 400 in India. In that case, all foreign customers would buy shirts from India. Similarly, any exchange rate below Rs 50 per dollar will send all the shirt business to the US. 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.” |