2019 Prof. Farok J. Contractor, Rutgers University
Also See the Companion Post:
Advantages and Drawbacks of Undervalued Versus Overvalued Currencies
The basic idea of purchasing power parity (PPP) theory is that money, as such, has no value. It is merely a piece of metal, paper, or plastic—or even a phantasmic electronic entry. What gives money value is what you can do with it—what and how much you can purchase.
PPP theory says simply that the exchange rate for a currency, in the long run, is based on the comparison of its purchasing power versus that of another currency. In the simplest example, if a basket of goods and services can be purchased for Rs 78,000 in India, and the same basket of goods and services can be purchased in the US for $1,000, then the PPP theoretical exchange rate should be $1 = Rs 78.
Unfortunately, all monies (currencies) eventually lose value through a mysterious process called “inflation.” Inflation is the erosion of a currency’s purchasing power over time, typically years. The complication is that different currencies lose purchasing power at different rates. In short, the currency that has a higher inflation rate, such as the Indian rupee, should (and indeed will, in the long run), according to PPP theory, devalue against a reference currency, such as the US dollar (USD), that suffers lower inflation.
A simple way of calculating this is to take the difference between the inflation rate of the rupee and that of the reference currency (e.g., USD) over a suitable period.
According to the
calculation of a thoughtful Indian business publication, LiveMint,* the Indian rupee should have devalued at a rate proportionate to the difference in the inflation between India and the US, calculated as an average annual 4.15 difference, as shown in the graph (click graph to see larger version in article*).
If this is so, each year, on average, the Indian rupee should have devalued by 4.15 percent. However, it did not. The rupee devalued more slowly—less than it should have according to PPP theory. That means the rupee is somewhat overvalued.
The author of the LiveMint article also tracks the rupee’s real effective exchange rate (REER), not just against the US dollar, but against a mix of India’s trading partner currencies. That analysis also reaches the same conclusion: that the rupee is overvalued.
Inflation in the Indian economy has moderated recently, but remains higher than in the US. If this continues in the long run, the theory says, we should expect the rupee to continue to devalue against the dollar.
*See Rajadhyaksha, N. (2018). Is the rupee undervalued or is it overvalued? LiveMint (October 8).
Also See the Companion Post:
Advantages and Drawbacks of Undervalued Versus Overvalued Currencies
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