The long run and real measures: PPP, real exchange rates, terms of trade

Detail

1. Purchasing power parity (PPP): the long-run anchor

• Purchasing power parity (PPP) means that, in the long run, exchange rates move until the same good costs the same in every country.
• The law of one price is the idea behind it. If a good is cheaper in one country, buyers move there, and the prices come back into line.

• It holds only under strict assumptions. There are no tariffs or quotas, and we ignore transport costs.

• Absolute PPP formula: e = P / P*

• e = the rupee price of one dollar.

• P = the Indian price level. P* = the foreign (US) price level.

• Main conclusion: over the long run, exchange rates reflect relative price levels. A country with higher inflation sees its currency depreciate (lose value).

• Relative PPP (the "change" version): % change in e ≈ Indian inflation − foreign inflation.

• Example: India has 6% inflation and the US has 2%. PPP then predicts that the rupee falls about 4% a year against the dollar.

• Why PPP fails in the short run:

• Many goods and services, such as haircuts and housing, cannot be traded.
• Tariffs, quotas and transport costs exist.
• Capital flows and speculation move the currency every day.
• So PPP is a long-run tendency. It does not predict tomorrow's rate.

2. The shirt example (Class 12, Example 6.1)

• Starting point: a shirt costs $8 in the US and ₹400 in India.

• PPP rate = 400 / 8 = ₹50/$.

• When the market rate is ₹60/$:

• The US shirt costs 8 × 60 = ₹480. The Indian shirt costs ₹400.

• All buyers go to India. Demand for rupees rises, and the rupee appreciates back towards ₹50/$.

• When prices change:

• Indian prices rise 20%, from ₹400 to ₹480.
• US prices rise 50%, from $8 to $12.
• New PPP rate = 480 / 12 = ₹40/$.
• The dollar depreciates (from ₹50 to ₹40) because US inflation was higher.
• Check with relative PPP: 1.20 / 1.50 = 0.8, so e falls 20% (50 → 40).

3. NCERT Q15: a PPP projection

• The rate is ₹30/$ in 2010. Indian prices double by 2030, and US prices stay flat.
• New rate = 30 × (2 / 1) = ₹60/$ in 2030.
• Lesson: if Indian inflation doubles the price level, PPP says the rupee loses half its value.

4. Other uses of PPP

• Big Mac index (from The Economist): an informal PPP check that compares the price of one burger across countries.
• Implied PPP rate = local burger price ÷ US burger price.
• If the implied rate is lower than the market rate, the local currency is undervalued.
• Worked example (made-up numbers): the burger costs ₹200 in India and $5 in the US. The implied rate is ₹40/$. The market rate is ₹85/$. So the rupee looks undervalued on the Big Mac test.

• Limitation: the burger includes rent and wages, which cannot be traded. Poorer countries usually look "undervalued" because their labour is cheap.

• PPP conversion rates are used to compare GDP across countries. They remove price-level differences, so the same money buys the same basket of goods everywhere.

• Market exchange rates make poor countries look smaller than they really are, because non-traded goods are cheap there.

• International Comparison Program (ICP): the global exercise that produces PPPs.

• It works under the UN Statistical Commission and is coordinated by the World Bank [3].
• The ICP 2021 round covered 176 economies. It was the tenth cycle since the ICP began in 1968 [3].

• The global economy in PPP terms was $152 trillion (2021) [3].

• India's rank: India was the third-largest economy in PPP terms, at about $11 trillion, or 7.2% of the world total (ICP 2021) [4]. It came after China and the US, and ahead of Russia, Japan, Germany, Brazil and France [4]. (NCERT: third-largest in PPP terms; cross-ref development-and-hdi.)

5. Nominal vs real exchange rate

• Nominal exchange rate (e): the rupee price of one unit of foreign currency, for example ₹85 per $1. This is the rate you see at the bank.
• Real exchange rate (R): the price of foreign goods in terms of domestic goods.
• Formula: R = eP* / P

• It tells us how many units of Indian goods we must give up to buy one unit of foreign goods.

• What a change in R does:

• R rises (real depreciation): foreign goods become dearer, so imports fall and exports rise. The trade balance improves.

• R falls (real appreciation): Indian goods become dearer abroad, so exports fall and imports rise.

• Why buying decisions depend on the real rate (NCERT Q3):

• Buyers compare actual goods prices, not just currency prices.

• Suppose the rupee depreciates 5% but Indian prices also rise 5%. R does not change, and India gains no competitiveness.

• When PPP holds exactly: e = P/P*, so R = 1. Movements of R away from 1 show departures from PPP.

6. NCERT Q4: calculating R with yen

• 1.25 yen buys ₹1, so ₹0.8 buys 1 yen (1 / 1.25 = 0.8). This gives e = 0.8.
• The Japanese price level P* = 3 and the Indian price level P = 1.2.
• R = eP* / P = 0.8 × 3 / 1.2 = 2.
• Meaning: one unit of Japanese goods costs as much as two units of Indian goods. Japanese goods are relatively dear, which helps Indian exports.

7. Effective exchange rates: NEER and REER

• Bilateral rate: a rate against one currency, such as ₹/$. The rupee can rise against the dollar and fall against the euro at the same time, so one bilateral rate can mislead.
• Nominal effective exchange rate (NEER): a trade-weighted average of the rupee's bilateral rates against a basket of partner currencies.

• A partner with a bigger share of India's trade gets a bigger weight.

• Real effective exchange rate (REER): the NEER adjusted for relative inflation (India's prices compared with partners' prices).

• It measures external competitiveness.

• RBI indices:

• The RBI publishes 40-currency and 6-currency NEER/REER indices, with base 2015-16 = 100 [2]. (NCERT scaffold: 40- and 6-currency, base 2015-16 = 100. The 40-currency basket and the base year are confirmed [2]; the 6-currency basket was not re-verified.)
• The 2021 revision moved the base year from 2004-05 to 2015-16 [2].
• It expanded the basket from 36 to 40 currencies. The basket now covers 88% of India's total trade, up from 84% [2].
• Currencies added (8): Angola, Chile, Ghana, Iraq, Nepal, Oman, Tanzania and Ukraine. Together they had 5.4% of India's merchandise trade [2].
• Currencies dropped (4): Argentina, Pakistan, Philippines and Sweden. Together they had only 1.4% of trade [2].
• Weights: time-varying bilateral trade weights, based on the geometric mean of India's trade (exports plus imports) with each partner over the preceding three years [2].
• Price index: the REER is CPI-based [2].
• Trend: the new REER stayed close to 100 for most of 2004-05 to 2019-20 [2].

• Methodology notes: RBI Bulletin issues of December 2005, April 2014 and January 2021 [2].

• How to read the index:

• In RBI's series, a rise in the index means the rupee appreciates.
• A REER above 100 signals overvaluation compared with the base year. Indian exports lose price competitiveness.

• A REER below 100 signals undervaluation, which helps competitiveness.

• Worked example (made-up numbers):

• NEER index = 95, Indian CPI index = 130, weighted partner CPI index = 110.
• REER = 95 × (130 / 110) ≈ 112.

• The rupee has fallen in nominal terms (NEER below 100). But because Indian inflation was higher, the real rate is overvalued by about 12%.

• Policy use: in today's managed float, the RBI watches the REER. It does not target any fixed level of the rupee, but it intervenes to smooth excess volatility.

8. NCERT Q16: fixed rate with higher home inflation

• Set-up: e is fixed, as under Bretton Woods or a peg. Indian prices P rise faster than foreign prices P*.
• Chain of effects:
• R = eP*/P falls. This is a real appreciation, even though e has not moved.
• Indian exports become dearer abroad, and imports become cheaper at home.

• The trade balance worsens.

• Worked example: e = 50, P* = 100 and P rises from 100 to 110.

• R falls from 50 × 100/100 = 50 to 50 × 100/110 ≈ 45.5.

• That is a real appreciation of about 9%.

• Historical link to 1991:

• Under the pegged and administered rupee, India's inflation stayed above its partners' for years. The rupee became overvalued in real terms.
• This added to the trade deficit behind the 1991 BoP crisis (balance of payments crisis).
• The rupee was devalued in July 1991 to restore competitiveness. Market-determined rates followed in 1993 (keec103).

9. Terms of trade (ToT)

• Terms of trade: the ratio of a country's export prices to its import prices.
• An improvement means one unit of exports now buys more imports.

• A deterioration means it buys fewer.

• Net barter terms of trade (NBTT) = (Px / Pm) × 100

• Px = export price index. Pm = import price index.

• Income terms of trade (ITT) = NBTT × export volume index (divide by 100 to keep it as an index).

• It measures the import-buying capacity of exports.

• It rises when either export prices or export volumes rise.

• Worked example:

• Export price index = 110 and import price index = 125, so NBTT = (110/125) × 100 = 88. ToT worsened by 12%.
• Export volume index = 120, so ITT = 88 × 120 / 100 = 105.6.

• Prices moved against India, but higher export volume still raised its capacity to import by 5.6%.

• India and oil:

• India imports most of its crude oil.
• An oil price spike raises Pm and worsens India's ToT. A fall in oil prices improves it.
• Higher oil prices also widen the merchandise trade deficit and the current account deficit (the gap when a country pays more to the world for goods, services and transfers than it receives).

• The Economic Survey 2019-20 noted that India's income terms of trade were on a rising trend. A likely reason was that crude prices had not risen faster than India's export prices [5].

• Prebisch-Singer thesis: countries that export mainly primary goods (farm produce and minerals) see their ToT decline over time against countries that export manufactured goods (cross-ref international-trade-policy).

• This argument supported the import substitution strategy (making goods at home instead of importing them) in India and Latin America from the 1950s to the 1980s.

10. Dutch disease

• Dutch disease: a boom in natural resources, remittances or capital inflows causes a real appreciation. This squeezes manufacturing and other tradables (goods that can be sold abroad).
• Chain of effects:
• A large inflow of foreign currency arrives, for example from gas exports.
• The currency appreciates. Alternatively, domestic prices and wages rise, so R falls either way.
• Factories that export or compete with imports lose price competitiveness.

• Labour and capital shift into non-tradables such as construction and services.

• Origin: the name comes from the Netherlands' Groningen gas discovery (1959). The term was coined in 1977.

• Relevance to India: large capital inflows or remittances could push the REER above 100. This is one reason the RBI builds forex reserves (sterilised intervention) during inflow surges.
• The resource curse is covered in growth-theories-business-cycles.

Prelims Hooks

• PPP assumes no tariffs, no quotas and no transport costs. Under PPP, long-run exchange rates reflect relative price levels.
• Real exchange rate R = eP*/P. A rise in R is a real depreciation, which improves the trade balance.
• Trap: under a fixed nominal rate, higher home inflation causes a real appreciation, not a depreciation.
• NEER is a trade-weighted average of nominal rates. REER is the NEER adjusted for relative inflation. A REER above 100 means overvaluation.
• The RBI's 40-currency NEER/REER uses base 2015-16 = 100. It replaced the 36-currency, 2004-05 series in 2021 and covers 88% of India's trade [2].
• Net barter ToT = (Px/Pm) × 100. Income ToT = NBTT × export volume index, which measures import-buying capacity.
• An oil price rise worsens India's ToT.
• The ICP, which produces PPPs, is coordinated by the World Bank. In ICP 2021, India was third-largest, at $11 trillion (7.2%) [3][4].
• Dutch disease is named after the Groningen gas find (1959). The term was coined in 1977.
• The Prebisch-Singer thesis says the ToT of primary-commodity exporters decline over time.

Mains Points

• Weak rupee vs strong rupee debate:
• The REER, not the ₹/$ rate, decides export competitiveness.
• A nominal depreciation that only matches the inflation gap gives no real gain.

• Policy should therefore focus on keeping inflation low and building productivity, not on pushing the rupee down.

• Lessons of the 1991 crisis:

• Under Bretton Woods-style pegs, persistent inflation gaps cause silent real appreciation. This widens the trade deficit and drains reserves.
• This happened in the run-up to 1991.

• The managed float with REER monitoring by the RBI is the institutional answer to that lesson.

• Oil and ToT vulnerability:

• India's dependence on imported crude makes its ToT and current account deficit sensitive to oil shocks.

• Energy diversification, strategic reserves and export diversification into higher-value goods protect the income terms of trade.

• PPP vs market-rate GDP:

• PPP-GDP (India third, 2021) [4] shows real output and living standards.
• Market-rate GDP decides global financial weight, debt capacity and quota-based voice, for example IMF quotas.
• Answers should use each measure for its proper purpose.