Exchange Rate Determination & Purchasing Power Parity (PPP)

1) Exchange rate: meaning

The exchange rate is the price of one currency in terms of another.

Example:

• ₹83 per USD means 1 USD = ₹83.

1.1 Bilateral vs effective exchange rate

• Bilateral: between two currencies (₹/USD).
• Effective exchange rate: weighted average against many trading partner currencies.

1.2 Nominal vs real exchange rate

• Nominal exchange rate (E): currency price.
• Real exchange rate (RER) adjusts for relative prices:

where:

• $P^*$ = foreign price level,
• $P$ = domestic price level.

Interpretation (concept):

• If RER rises, domestic goods become relatively cheaper/more competitive (depending on definition); focus on idea that RER adjusts nominal rate by inflation differences.

2) Appreciation vs depreciation (very testable)

Using the quote “₹ per USD”:

• Depreciation of rupee: ₹ per USD increases (₹83/USD → ₹85/USD).
  Rupee becomes weaker; imports costlier; exports more competitive.
• Appreciation of rupee: ₹ per USD decreases (₹83/USD → ₹80/USD).
  Rupee becomes stronger; imports cheaper; exports less competitive.

3) Exchange rate regimes

3.1 Fixed exchange rate

Government/central bank maintains E at a target value using:

• forex intervention (buy/sell reserves),
• capital controls,
• interest rate changes,
• devaluation/revaluation (official change).

3.2 Flexible (floating) exchange rate

E determined by market demand and supply for foreign exchange.

3.3 Managed float (practical reality for many countries)

Mostly market-determined but central bank intervenes to reduce excessive volatility.