Macro Economics Exam Tips

 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