How do you fix the formula of Exchange Rate Determination under Purchaisng Power Parity Theory ?

Question

Let us suppose that now the rate between India and the UK is

GBP 1 = INR 60 Under Purchasing Power Parity

Suppose, the price index in India rises to 300 and in the UK rises by 200

Now, what will be the new exchange rate as per the same thoery.

Let us suppose that now the rate between India and the UK is

GBP 1 = INR 60 Under Purchasing Power Parity

Suppose, the price index in India rises to 300 and in the UK rises by 200

Now, what will be the new exchange rate as per the same thoery ?

Answer 1

Purchasing Power Parity simply states that, in the long run, a basket of goods will cost the same in country A as it costs in country B. The adjustment to achieve the parity is done through three levers: The exchange rate, inflation and the interest rate, although inflation and interest rates are part of the same lever.
For example, if GB and India were in "equilibrium" and suddenly India experiences an increase in inflation, the Purchasing Power Parity theory states that the exchange rate between the GB currency and the Indian currency will adjust, in the long term, to insure that there are no differences between buying a basket of goods in GB or in India.
In reality, the effect of Purchasing Power Parity is clouded by transaction costs and restrictions in capital flows between countries.

Answer 2

I'm not quite sure what you question is. Purchasing Power Parity is a theory that suggests that the exchange rate between two countries (X and Y) should adjust so that the overal price of a typical basket of goods in country X is equal to the overall price of that basket of goods in country Y.

Hope that helps.

Answer 3

Essentially, one takes the cost of goods across nations; and fixes the difference in costs to an exchange rate.

The actual rate doesn't hold true, but the upward and downward trend are close to what we observe in real life.

Answer 4

C.Inflation rates