Purchasing Power Parity (PPP), Market Exchange Rate vs Exchange Rate (PPP), Implications of Higher GDP (PPP)

 

PURCHASING POWER PARITY (PPP):-

• Purchasing power parity (PPP) is a form of Exchange Rate that takes into account the cost of a common basket of goods and services in the two countries compared.
• It is the measure of the actual purchasing power of those currencies at a given point in time for buying a given basket of goods and services.
• Purchasing power parity (PPP) is often expressed in U.S. dollars.
• Purchasing Power Parity (PPP) exchange rate is not directly observable – there is no market where you can buy or sell currencies at PPP exchange rates. 

To Understand:

NER 1 $=80 Rs.

Let 1 chocolate cost =Rs 20 in India

Cost of same chocolate = 1 $ in US.

As 1 $ and the 20 Rs are in a position to purchase the same amount of items in US and India respectively so there purchasing power is same in their respective countries.

So as per definition, this Exchange Rate ie 1 $ =20 Rs is nothing but Purchasing Power Parity.

• Value of dollar in this reference is Rs 20 ie Exchange rate is 1$ =Rs 20 but this exchange rate is different than market Exchange Rate ie NER and it is referred to as ER (PPP).
• Both currencies  ie either one dollar in US has the same purchasing power as that of 20 Rs in India.

 Why difference between Exchange Rate and Exchange Rate (PPP):

What affects Market Exchange Rate:

• Foreign currency is required for multiple reasons in the international market ie for trade, speculation, investment and other reasons and this creates a market of demand and supply or that currency in the market so Exchange Rate -Market is always higher than ER-PPP.
• The market exchange rate tells you how many rupees you can buy for $1,000, the PPP exchange rate tells you how many rupees you would need in India to maintain the same standard of living you could achieve in the United States for, say, $1,000 per month.

The relative version of PPP is calculated as: 

REER = NEER *Domestic Price/Foreign price

            =NEER* ER(PPP)

STATUS OF INDIAN ECONOMY:

India is 5^th largest economy in nominal terms while 3^rd on PPP terms.

HIGHER GDP IN PPP TERMS FOR INDIA-What does that mean :

• The implications of a high GDP in PPP terms can be understood in terms of increasing strength of the Indian consumer in recent years. 
• A high PPP implies that a basic set of essential goods and services is cheaper inside India, in comparison to the consumers in Japan, USA or the UK. 
• India has made significant improvements in public life and economy allowing for a low cost of living, across the population. 
• This has also resulted in India being generally safe against inflation shocks and shocks of the global economy.