Page 180 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes According to the theory, the exchange rate between two countries is determined at a point which
expresses the equality between the respective purchasing powers of the two currencies. This is the
purchasing power parity which is a moving par and not fixed par (as under the gold standard). Thus
with every change in price level, the exchange rate also changes. To calculate the equilibrium exchange
rate, the following formula is used :
Domestic Price of a Foreign Currency × Domestic Price Index
R = Foreign Price Index

This is what the formula does. Let us explain it in terms of our above example. Before the change in
the price level, the exchange rate was Rs. 60 = £ 1. Suppose the domestic (Indian) price index rises to
300 and the foreign (England) price index rises to 200, thus the new equilibrium exchange rate will be
×
£ 1300
R = = £ 1.5
200
or Rs. 60 = £ 1.5
This will be the purchasing power parity between the two countries. In reality, the parity will be
modified by the cost of transporting goods including duties, insurance, banking and other charges.
These costs of transporting goods from one country to another are, in fact, the limits within the
exchange rate can fluctuate depending upon the demand and supply of a country’s currency. There
is the upper limit, called the commodity export point; and the lower limit, known as the commodity
import point. (These limits are not as definite as the gold points under the mint par theory).

D S
1 1
D S
£)
per Commodity
Export Point
(Rs. R 1 E 1
Rate R E D Purchasing
Power Parity
Exchange 1 Commodity

Import Point
S
1
S D
O Q
Quantity of Foreign Exchange

Figure 15.1
The purchasing power parity theory is illustrated in Figure 1 where DD is the demand curve for
foreign currency (pound in our example) and SS is the supply curve of currency. OR is the rate to
exchange of rupees per £ , which is determined by their intersection at point E so that the demand for
the supply of foreign exchange equals OQ quantity. Suppose the price level rises in India and remains
constant in England. This makes Indian exports costly in England and imports from England relatively
cheaper in India. As a result, the demand for pounds increases and the supply of pounds decreases.
Now the DD curve shifts upward to the right to D D and the SS curve to the left to S S . The new
1 1 1 1
equilibrium exchange rate is set at OR rupees per pound, which represents the new purchasing
1
power parity. The exchange rate rises by the same percentage as the India price level. The purchasing
power curve shows that with relative change in the price levels, the exchange rate tends to fluctuate
along this curve above or below the normal exchange rate. But there is a limit upto which the purchasing
power parity curve can move up and down. The upper and lower limits are set by the commodity
export point and the commodity import point respectively.

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