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.
Solution
The rupee-dollar exchange rate is given as Rs.30 in the year 2010. This implies that the price of a good (say, book) is $1 in USA and Rs.30 in India. It is given that prices have doubled in India over 20 years while they have remained fixed in the USA, so the cost of the book will be Rs. 60 in 2030 and the cost of the book remains the same i.e $1 in the USA since the prices are not changing. For these two prices to be equivalent, Rs.60 must be worth of $1. The rupee, therefore, will depreciate.
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