DMPQ-Explain how exchange Rate and Purchasing Power Parity effect each other.

Exchange rates in the ideal sense be a reflection of differences in purchasing power of economies on account of various factors. However, this is true only if the entire global world had free trade, without any restrictions, ability of goods to move across geographies without any hindrance, similar like a bird flying, ability to reach any part of the world.

However, the reality is quite the contrary with restrictions to trade, tariffs and non-tariff barriers to trade. Exchange rates are influenced by many other factors such as inflows, thus completely diluting it as a measure of differential purchasing power across countries.

If the Indian Rupee is appreciating against the USD, it does not imply improvement in the purchasing power. By using the conventional exchange rate, without adjustment for purchasing power would not be a correct measure for comparison of economies in a common currency.

Thus, was borne the concept of purchasing power parity (PPP) which is the adjustment made to the exchange rate such that they truly represent differences in purchasing power. PPP is now a globally accepted methodology being used for all international comparisons but all actual transactions in foreign currency and their conversion would continue to’ be guided by the conventional exchange rate.

Thus, all comparisons of GDP and GNI per capita is done both by using the conventional exchange rates for USD of economies and also on adjusted exchange rate or at PPP. The use of USD as a common denominator, for all international comparison purposes is for historical reasons and also because of the US being the largest economy in terms of its output.

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