Market Exchange Rate & Purchasing Power Parity (PPP - Exchange Rate)
"If you don't find a way to make money while you sleep, you will work until you die"
Market Exchange Rate - It is the rate at which one can trade one currency with another.
In other words, it refers to the real exchange rate for foreign trading in a free market.
It depends on the inflow and outflow of foreign currency ($).
Inflow of foreign currency ($)
- Export
- Foreign tourists
- Foreign investors (FDI)
- Foreign remittances
- Foreign borrowings, etc.
Outflow of foreign currency ($)
- Import
- Indian tourists visiting abroad
- Indian investors investing abroad
- Withdrawal of foreign investment
- Lending, etc.
It works on the principle of market mechanism of demand and supply (of foreign currency, $).
Note - Here, market refers to Inter-Bank forex market.
Therefore, the outflow of $ results into depreciation of ₹/appreciation of $ and the inflow of $ results into appreciation of ₹/depreciation of $.
For Example - Increase in import → increase in outflow of $ → demand of $ increases → price of $ wrt ₹ increases → depreciation of ₹.
Therefore, government imposes various restrictions to decrease import (outflow of $) and encourage export (inflow of $). Government also makes FDI norms liberal so as to increase foreign investment (inflow of $) which led to appreciation of ₹.
Purchasing power parity (PPP) - It is an exchange rate system under which exchange rates of various currencies are determined on the basis of their relative purchasing powers in the respective country.
i.e., what $ can buy in USA = How many ₹ needed to buy the same is PPP (which is approximately, $1 = ₹17).
It means what $1 can buy in USA = what ₹17 can buy in India.
It is calculate by finding mean by collecting sample spaces of similar products in different countries.
It is estimated by UNICP (United Nations International Comparison Program).
It is used to compare Standard of living across different countries.
It is relatively stable than the market exchange rate.
Difference between Market Exchange Rate and Purchasing Power Parity
Market Exchange Rate
- It is based on demand and supply of $.
- It is usually greater than PPP (as $ is a hard currency and its demand is much high in international market).
- It is used for actual transaction (in international trade).
Purchasing Power Parity
- It is based on actual purchasing power of the currency.
- It is usually lesser than Market Exchange Rate.
- It is used for international comparison of GDP, PCI, GNP, etc.
Price level index (PLI) - It is the ratio of Purchasing Power Parity to the Market Exchange Rate.
If an economy's Price level index is less than another economy, then its item or expenditure aggregates are less expensive than the other's economy.
GDP (Market Exchange Rate) - Atlas method/Nominal GDP prepared by World Bank
Top countries in terms of Market Exchange Rate -
- USA
- China
- Japan
- Germany
- UK
- India
- France
GDP (PPP) - International $ method prepared by World Bank
Top countries in terms of Purchasing Power Parity -
- China
- USA
- India
- Japan
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Note - This is my Vision IAS Notes (Vision IAS Class Notes) and Ashutosh Pandey Sir's Public Administration Class notes. I've also added some of the information on my own.
Hope! It will help you to achieve your dream of getting selected in Civil Services Examination 👍
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