Model Answer
0 min readIntroduction
The nominal exchange rate, representing the price of one currency in terms of another, is often perceived as a direct indicator of the relative competitiveness of a country’s goods in the international market. A depreciating Rupee, for instance, is generally expected to make Indian exports cheaper and imports more expensive, thereby improving the trade balance. However, the relationship between nominal exchange rate movements and the relative prices of goods – captured by the concept of Purchasing Power Parity (PPP) – is far more complex than a simple one-to-one correspondence. This answer will explore the extent to which Rupee movements reflect corresponding movements in Indian goods vis-a-vis foreign goods, highlighting the factors that cause deviations from this theoretical relationship.
The Theoretical Link: Purchasing Power Parity (PPP)
The absolute version of PPP suggests that exchange rates should adjust to equalize the price levels of identical goods and services across countries. For example, if a basket of goods costs $100 in the US and ₹8000 in India, the exchange rate should be ₹80/$. The relative PPP, a more realistic version, posits that the *change* in the exchange rate should equal the difference in inflation rates between the two countries. If India’s inflation is 5% and the US’s is 2%, the Rupee should depreciate by approximately 3% against the dollar.
Deviations from PPP: Why the Rupee’s Movement Isn’t Always Reflective of Goods Prices
Several factors cause significant deviations from PPP, making the Rupee’s movement an imperfect indicator of relative goods prices:
- Non-Traded Goods & Services: A significant portion of GDP consists of non-traded goods and services (e.g., haircuts, real estate, government services). Prices of these goods are determined by domestic supply and demand and are not directly affected by exchange rate movements.
- Trade Barriers & Transportation Costs: Tariffs, quotas, and transportation costs prevent goods from being freely traded, creating price discrepancies across countries.
- Product Differentiation: Goods are rarely identical across countries. Differences in quality, branding, and consumer preferences affect prices.
- Financial Flows & Capital Mobility: Large capital inflows (e.g., Foreign Portfolio Investment - FPI, Foreign Direct Investment - FDI) can appreciate the Rupee, even if India’s trade balance is deteriorating. Conversely, capital outflows can depreciate the Rupee. This is often more dominant than trade flows in the short to medium term.
- Speculation & Market Sentiment: Exchange rates are heavily influenced by speculative trading and market expectations. Rumors, political instability, or changes in global risk appetite can trigger significant exchange rate fluctuations unrelated to goods prices.
- Interest Rate Differentials: The uncovered interest parity condition suggests that exchange rates adjust to offset interest rate differentials. Higher interest rates in India can attract capital inflows, appreciating the Rupee, regardless of trade flows.
Empirical Evidence & Recent Trends
Empirical studies consistently show that PPP holds poorly in the short to medium run. While there is some evidence of long-run convergence towards PPP, the relationship is weak and often overshadowed by other factors.
For example, in 2022, despite India experiencing relatively high inflation compared to the US, the Rupee did not depreciate by the full extent predicted by relative PPP. This was largely due to strong portfolio inflows into the Indian stock market and a relatively stable global risk environment. Conversely, in 2023, despite relatively contained inflation, the Rupee faced depreciation pressure due to global dollar strength and geopolitical uncertainties.
The Role of the Reserve Bank of India (RBI)
The RBI actively intervenes in the foreign exchange market to manage volatility and prevent excessive Rupee fluctuations. RBI’s interventions, through buying or selling dollars, can significantly influence the exchange rate, further decoupling it from underlying goods prices. The RBI’s focus is often on maintaining financial stability and preventing disruptions to trade, rather than strictly adhering to PPP.
| Factor | Impact on Rupee-Goods Price Relationship |
|---|---|
| Capital Flows | Can dominate trade flows, causing exchange rate movements independent of goods prices. |
| Speculation | Introduces volatility and short-term fluctuations unrelated to economic fundamentals. |
| RBI Intervention | Directly influences the exchange rate, potentially offsetting PPP effects. |
| Non-Traded Goods | Limits the extent to which exchange rate changes affect overall price levels. |
Conclusion
In conclusion, while the nominal exchange rate of the Rupee is theoretically linked to the relative prices of Indian and foreign goods through PPP, the relationship is often weak and overshadowed by a multitude of other factors. Financial flows, speculation, RBI intervention, and the presence of non-traded goods all contribute to deviations from PPP. Therefore, the Rupee’s movement should not be solely interpreted as a direct reflection of changes in the competitiveness of Indian goods. A comprehensive understanding of macroeconomic conditions and global financial dynamics is essential to accurately assess the implications of exchange rate fluctuations.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.