NOMINAL AND PPP EXCHANGE RATE
Nominal exchange rate (NER )
- Definition – NER is value of foreign currency expressed in terms of domestic currency .
- Explanation – Suppose we say that value of 1 Dollar is equal to ₹ 100 , then this statement can be mathematically written as $1 = ₹100 . So this equation is basically expressing NER .
- Now question arises , why the name “Nominal exchange rate ” ? – We call it by the name Nominal exchange rate because word Nominal is always used to express money in Economics . That is why the above equation would be called as NER .
So , it can be concluded that if someone wants to get $1 , he can get it by paying ₹100 . On the other hand if someone wants to get ₹100 , he can get by paying $1 .
Factors affecting NER
- NER depends on market forces of demand and supply .
- Explanation – Let us understand this statement with the help of an example . Suppose current NER is $1 = ₹100 . Now suppose that demand of dollar ($) suddenly starts increasing , due to this the value ( importance ) of dollar will increase . So , increase in the value of dollar would simply mean that more rupee would now be required to purchase one dollar .
- Hence we can say that the equation would move from $1 = ₹100 to 1$= ₹120 . This is a hypothetical value , don’t get confused that how come 120 . It can be any value say 110 or 130 or 150 etc.., but more rupee has to be paid , this is the crux .
- Similarly , if demand of dollar decreases , then value of dollar will decrease . It would mean that the original equation would move from $1 = ₹80 .
- Now , suppose supply of dollar increases , then value of dollar will decrease .
- Also , when supply of dollar decrease , value of dollar will increase .
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PPP exchange rate
Let us understand this with the help of an example . Suppose , a pizza costs ₹50 in India and the same quality pizza costs $1 in USA . It can be mathematically written as –
- $1 = 1 Pizza in USA ..( equation 1 )
- ₹50= 1 Pizza in INDIA..( equation 2 )
- By comparing above two equations , we can say that $1 = ₹50 . ( This is PPP rate )
So , this exchange rate we have developed by comparing the purchasing capacity of dollar and rupee .
- PPP definition – PPP exchange rate can be defined as the exchange rate which is derived by comparing the purchasing power of two different currencies in their respective countries .
Factor affecting PPP
- PPP exchange rate depends on inflation .
- Suppose , in India due to inflation , price of pizza went up to ₹ 80 . So , the earlier PPP rate ( $1=₹50) will move to $1=₹80. But if , inflation rate in both countries are same then price of pizza will rise by same percentage in both the countries .
- Conclusion – we can conclude that if inflation rate is same in both the countries then PPP rate will not change , but if inflation rate is different in both the countries then PPP rate will change .
- PPP rate calculation – For , practical purposes , we should also know how PPP exchange rate is calculated internationally . Actually , a basket of commodities are taken , say the basket contains pen , pencil , pizza , rice , wheat , vegetables etc.. then all these commodities would be considered as a basket of commodity and then their overall prices would be compared in both countries to get PPP rate .
Impact of PPP and NER on export and Import
- Now let us understand the relation of export and import with NER and PPP rate . But to understand this , we are assuming that the transportation cost between two countries is zero . Now , suppose NER is $1 = ₹100 and PPP is $1 = ₹50 .
- So , definitely an American would have to spend $1 to buy a pizza in America . On the other hand an Indian will purchase same pizza by paying ₹50 in India . But When we see at NER , which is $1 = ₹100 then , if an American gets his dollar converted into rupee , he can purchase 2 pizza in India .
- So , in this situation , India will export pizza to America OR America will import pizza from India ( Remember we have assumed that transportation cost is zero ) .
- On the other hand , suppose inflation is very high in India and the same pizza , due to inflation would now cost ₹100. So here PPP would change and new PPP rate would be $1=₹100.
- Now this PPP is equal to NER . So , here export would stop because there is no gain to Americans in importing pizza from India . Because PPP and NER both are equal now .
- Conclusion – So , from above analysis we can conclude few statements –
1. Whenever NER is more than PPP , domestic country will export .
2. When NER is equal to PPP , export will stop .
3. When NER is less than PPP , domestic country will import .