Question 13 of 17intermediate🔧 ApplyNumerical4 marks

Suppose the exchange rate between the Rupee and the dollar was Rs. 30=1$ in the year 2010. Suppose the prices have doubled in India over 20 years while they have remained fixed in USA. What, according to the purchasing power parity theory will be the exchange rate between dollar and rupee in the year 2030.

Correct Answer

According to the purchasing power parity theory, the exchange rate in the year 2030 will be Rs. 60 = 1$.

Step 1: Understand the given data

  • Exchange rate in 2010: Rs. 30 = 1$
  • Prices in India have doubled over 20 years (100% increase)
  • Prices in USA have remained fixed (0% increase)

Step 2: Apply the PPP principle According to the purchasing power parity theory, exchange rates adjust to reflect differences in price levels between two countries. The same product should cost the equivalent amount in both countries.

Step 3: Calculate the new exchange rate If a product cost Rs. 30 in India and $1 in USA in 2010, then in 2030:

  • The same product will cost Rs. 60 in India (prices doubled)
  • The same product will still cost $1 in USA (prices fixed)

For these two prices to be equivalent, $1 must be worth Rs. 60.

Step 4: Conclusion The new exchange rate in 2030 will be Rs. 60 = 1$. The rupee has depreciated as we need to pay more rupees for one dollar now.

Exercise: EXERCISES | Q: 15 | (Page Page 12)
For More Understanding

Explanation

This question tests the understanding of Purchasing Power Parity (PPP) theory. The context from Example 6.1 demonstrates that when prices change differently in two countries, the exchange rate must adjust to maintain purchasing power equivalence. In this case, since prices doubled in India (100% inflation) while remaining fixed in USA (0% inflation), the rupee depreciates proportionally. The calculation follows the same logic as the textbook example where a 20% price rise in India and 50% price rise in USA led to a new exchange rate of Rs. 40 = 1fromRs.50=1 from Rs. 50 = 1.

Solution Steps

  1. Step 1: Identify initial exchange rate (2010): Rs. 30 = 1$

  2. Step 2: Note price changes - India: doubled (×2), USA: fixed (×1)

  3. Step 3: Apply PPP formula: New Exchange Rate = Old Rate × (Price change in India ÷ Price change in USA)

  4. Step 4: Calculate: Rs. 60 = 30 × (2 ÷ 1)

  5. Step 5: Conclude: Exchange rate in 2030 = Rs. 60 = 1$

PreviousNext