purchasing power parity

Discussion in 'CT7' started by neha.neu, Oct 12, 2009.

  1. neha.neu

    neha.neu Member

    i am having a problem solving questions on purchasing power parity. I am getting all confused with nominal and real exchange rates.
    could someone please help me with it and give a detailed explanation to the questions which follow.

    One of the questions was :

    the average cost of a motorcycle in india is Rs. 30000 while in vivaland it is 36000 vivas, where viva is the official currency.the exchange rate is currently rs. 1=3 vivas

    1) Explain briefly what is meant by real exchange rate and calculate it in terms of the no. of vivas/rs.

    2)Determine the nominal exchange rate in terms of viva/rs. that is implied by purchasing power parity.

    3) comment on your answer.

    And another was :

    If Rs. is currently worth $2.The inflation rates for the next year are forecast to be 4% in india and 2% in US. If the purchasing power theory holds, what is forecast for the value of rs. in terms of $ one year from now?
     
    neha.neu, Oct 12, 2009
    #1
  2. freddie

    freddie Member

    The main formula to remember is:

    The real dollar/R = nominal $/R x (Index of Indian prices/Index of US prices)

    The PPP theory says that the nominal $/R exchange rate will adjust to changes in prices so that the real $/R exchange rate stays the same. For example, if prices in India double, the nominal $/R exchange rate will fall by 50%.
     
    freddie, Oct 14, 2009
    #2
  3. neha.neu

    neha.neu Member

    The formula is very convenient to remember . What i don't get is

    1. how to go about the questions. like in the first question they say the exchange rate currently is RS. 1= 3 vivas . Is this the nominal exchange rate or the real exchange rate? How do we know?

    2. the second part of the first question says determine the nominal exchange rate in terms of viva/rs. implied by ppp

    the cited solution is :

    ppp theory says the real exchange rate in both countries should be same i.e. it should be 1 . therefore the nominal exchange rate implied by ppp is 1=nominal viva/rs. exchange rate * (30000/360000)

    why should the real exchange rate be 1??

    3. In the second ques why is the current exchange rate taken to be the real exchange rate and not the nominal exchange rate as done in 1st part of the first questn??
     
    neha.neu, Oct 15, 2009
    #3

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