SEMESTER – II

MACROECONOMIC

    5.   Explain
the concept of purchasing power parity income

ANS:

The purchasing power parity theory of exchange rate determination was put forward by Professor Gustav Cassel of Sweden in the year 1920. There are two versions of the PPP theory known as the absolute and the relative versions.
According to the absolute version, the exchange rate between two
currencies should be equal to the ratio of the price indexes in the
two countries. The formula for the absolute versions of the
theory is as follows:

RAB = PA/PB

Here, RAB is
the exchange rate between two countries A and B and ‘P’ refers to the price index. The absolute version
is not used because it ignores transportation costs and other factors
which hinder trade, non-traded goods, capital flows and real
purchasing power.

The relative version which is widely used by Economists can be illustrated as follows. Let us assume that India and the
United States are on inconvertible paper standard and the domestic purchasing power of $1 in the US is equal to Rs.45 in
India. The exchange rate would therefore be $1 = Rs.45. Assuming the
price levels in both the countries to be constant, if the
exchange rate moves to $1 = Rs.40, it would mean that less rupees are
required to buy the same bundle of goods in India as compared to $1
in the US. It means that the US dollar is overvalued and the
Indian Rupee is undervalued. Appreciation of the rupee will discourage exports and encourage imports in India. As a result, the
demand for USD will increase and that of INR will fall till the
PPP exchange rate is restored at $1 = Rs.45. Conversely, if the exchange
rate moves to $1 = Rs.50, the INR is overvalued and the USD is undervalued. This will encourage exports and discourage
imports till once again the PPP exchange rate is restored.

According to the PPP theory, the exchange rate between two countries is determined at a point of equality between
the respective purchasing powers of the two currencies. The PPP exchange rate is a moving par which changes with the
changes in the price level. To calculate the equilibrium exchange rate
under the relative version of the theory, the following formula
is used:

         
                                   PA1 ∕ PA0

                            R = R0 × —————

                                            
PB1∕ PB0

Where 0     =       base period,

1       =       period one,

A&B =       Countries
A and B.

P       =       Price Index.

R0     =       Exchange rate in the
base period.

Assuming the price index of Country ‘A’ (India) to be 100
in the base period and 300 in period one and that of United
States to be 100 and 200 in the two periods respectively and the
Original exchange rate to be Rs.40, the new PPP exchange rate would
be as follows:

               300∕
100       300     100      3

R=40 × ————— = —— × —— = — = 1.5 = Rs.60

              
200 ∕ 100      100     200      2

Thus Rs.60/- or $1 = INR 60 will be the new PPP exchange
rate. However, the PPP exchange rate will be modified by the cost
of transporting goods including duties, insurance, banking and
other charges. These costs are the limits within which the
exchange rate can fluctuate given the demand supply situation. These
limits are the ‘upper limit’ or the commodity export point and the
‘lower limit’ or the commodity import point.

Critical Assessment of the PPP Exchange Rate
Theory. The

PPP theory is criticized on the following grounds:

1.  Price Indices of Two Countries
are not comparable.

The base year of indices in two countries may be different.
The consumption basket may also be different. The PPP rate may not therefore
give an accurate exchange rate based on the relative purchasing powers of any
two currencies. 

2.  Base Year is Indeterminate.

The theory assumes that the balance of payments is in
equilibrium in the base year. It is difficult to find the base year in which
the balance of payment was in equilibrium. 

3.  
Capital Mobility Influences
the Price Level.

The theory assumes that there is no capital mobility. The
general price level does not affect items such as insurance, shipping, banking transactions
etc. However, these items influence the exchange rate.

4. Changes in the Exchange Rate affects the
General Price Level.

When the exchange rate depreciates, the domestic price level
is influenced by the rise in import prices. Demand for exports increases,
thereby raising the price of export goods. Conversely, when the exchange rate
appreciates, exports are affected and imports become cheaper, thus bringing
about a fall in the price level.

5. Laissez Faire does not exist.

The theory is based on the policy of laissez-faire.
However, laissez faire does not exist. International trade is greatly
influenced by restrictive and protective trade policies. Non-market forces
therefore influence the exchange rate. 

6. Elasticity of Reciprocal Demand influences
Exchange Rates.

According to Keynes, the theory neglects the influence of elasticity
of reciprocal demand. The exchange rate is not only determined by relative
prices but also by the elasticity of reciprocal demand between trading
countries. 

7. Changes in the Demand for Imports and
Exports influence Exchange Rate.

The exchange rate is not determined by purchasing power
parity alone. The demand for imports and exports also influence exchange rate.
If the demand for imports rise, purchasing power parity remaining constant, the
exchange rate will rise and vice versa.

Conclusion

In spite of the limitations, the PPP exchange rate theory
is widely used in development economics to ascertain the real level of development
of an economy. The theory is therefore useful and PPP exchange rate is
therefore a useful macroeconomic tool. Haberler in support of the theory says
that, “While the price levels of different countries diverge, their price
systems are nevertheless interrelated and interdependent, although the relation
need not be that of equality. Moreover, supporters of the theory are quite
right in contending that the exchanges can always be established at any desired
level of appropriate changes in the volume of money.

 

  NATIONAL
INCOME CONCEPTS GNP, GDP & NDP

A)  GROSS
NATIONAL PRODUCT (GNP)

The GNP is the most widely
used measure of national income. It is the basic
accounting measure of the total output of goods and services. GNP is
defined as the total market value of all final goods and services
produced in a year. It measures the market value of a yearly
output and therefore it is a monetary measure of national income. In
the definition above, the term ‘final’ is used to avoid the
possibility of double counting and to ensure that only the value of final
goods and services is considered in measuring GNP. This is because
the value of intermediate goods is included within the value
of final goods and services. The term ‘gross’ refers to the fact
that depreciation or capital consumption of goods has not been subtracted
from the value of output. While measuring the GNP, only the
final value of goods and services is considered, i.e., the value is
added in each stage of the production process. For instance, there
are many stages in the production of bread. The farmer produces
wheat. The miller converts wheat into flour. The baker bakes the
bread and finally the bread is sold by the retailer to the consumer.
The value addition process in the production of bread is shown
in Fig. 1.1.

As shown in Fig.1.1, value is
added to the product at every stage of production as cost is
incurred at every stage of value addition. The final value of
the bread is the total of the value added at each stage. Suppose in the
second stage, if we add up Rs.7 instead of Rs.2 and in the
third sage Rs.12 instead of Rs.5 and so on then it will be a case of
multiple counting. This will give a wrong and inflated picture of the
actual value of the product produced in each period.

The rate of growth of GNP is
the most important indicator of the nation’s economy. It shows
the rate at which the national income of a country is
increasing or decreasing. It is the broadest statistical aggregate of an
economy’s output and growth. The estimate of national income in
terms of GNP provides the policy makers and business community
a useful tool to analyze the economic performance of the
country.

In an open economy, the value
of GNP at market prices may be symbolically stated as
follows:

GNP(MP)
= C + I + G + Xn + Rn, where:

GNP(MP)   =       Gross
National Product at market prices.

C                =       Consumption
goods.

I                  =       Investment
goods.

G                =       Government
services.

Xn               =       Net
exports i.e. exports minus imports.

Rn              =       Net
receipts i.e. receipts minus payments.

 

GNP is the basic accounting
measure of national output and represents final products
valued at current market prices.  

 

B)  GROSS DOMESTIC
PRODUCT AT MARKET PRICES (GDPMP)

The Gross Domestic Product
refers to the value at market

prices of goods and services
produced inside the country in each

year. It can be stated as
follows:

GDPMP
= C + I + G + (X – M)

Where,

C       =       Consumption goods.

I         =       Capital goods
or Gross investments.

G       =       Government
Services.

X       =       Exports, and

M      =       Imports.

Here, (X – M) refers to net
exports or Xn which can be

positive or negative. If
exports are greater than imports, net

exports will be positive and
vice versa. Net positive exports will

lead to rise in GDP and net
negative exports will lead to fall in GDP.

 

NET DOMESTIC PRODUCT (NDP)

While calculating the GDP, no
provision is made for

depreciation or capital
expenditure. Net Domestic Product is

arrived at by subtracting
depreciation from the GDP. Depreciation

is accounted for because
factories, buildings etc., get depreciated

over their life time during
their use in the production process.

These goods need replacement
once their life is over. Hence, a

part of the replacement cost
of the capital is set aside in the form of

depreciation allowance.
Symbolically, Net Domestic Product can

be stated as follows:

NDP =GDP – D

Where, D=Depreciation. 

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