Exchange Rate of the Rupee and Purchasing Power Parity

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Exchange Rate of the Rupee and Purchasing Power Parity Author(s): Ashok K. Nag and Amit Mitra Reviewed work(s): Source: Economic and Political Weekly, Vol. 33, No. 25 (Jun. 20-26, 1998), pp. 1525-1532 Published by: Economic and Political Weekly Stable URL: http://www.jstor.org/stable/4406906 . Accessed: 02/01/2013 03:20 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp

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SPECIAL ARTICLES

Exchange

Rate

the Power

of

Rupee Parity
Ashok K Nag Amit-Mitra

and

Purchasing

The authors examine the rupee-dollar rate, the principal exchange rate in the Indian market, in the light of the Purchasing Power Parity theory. Such an examiniation has some importantpolicy intplications. The Committee on Capital Account Convertibility has recommended a Monitoring Exchange Rate Band of ?5 per cent around the neutral REER. An intervention regime that tracks movenent in REERfrom a neutral base period rate implies that an equilibrium exchange rate can be worked out on the basis of PPP. How valid is this presumption? AS an empiricaleconomic propositionthe powerparity(PPP)theorymerely purchasing that states international pricesof traded goods and services when converted to a common currency should equalise across national boundaries.If allowances are made for the effect of tariffand non-tariff pricedistorting to barriers tradethere is no reason why law of one price(LOP)should not hold good for the tradedgoods and services at the world in traders goods level. Existenceof arbitrage marketshould ensure that. Like anothersimilarly simple and almost obviousempiricalpropositionlike Quantity Theoryof Money, PPP has been converted intoa theoryof exchangeratedetermination. Thus Cassel (1921) viewed PPP as a determinantof "true equilibrium of the There are many, however, who exchange". have questionedthe validity of the PPP as and a theoryof exchangeratedetermination accordedsome value to the doctrine only are when"disturbances mainlyof a monetary origin". Theempiricalvalidityof the PPPhas been examined extensively in the literatureon exchange rate, particularly in respect of exchangerateof developed countries. [See forexample,Edison(1987), FisherandPark (1991), Geneberg(1978), Johnson (1990), Kim(1990), Manzur(1990), Officer (1976) and Taylor (1988)]. The broad consensus that has emerged in the literaturehas been by aptlysummarised Rogoff( 1996), "While few empiricalliterateeconomists take PPP seriouslyas a short-termproposition,most instinctively believe in some variant of purchasingpower parity as an anchor for long run Real Exchange Rate". As we all know, the international currencymarketis notoriouslyvolatile and the practicalutility of a theory that provides clues only to the long-termtrendsin the marketis doubtful. In this paperwe examine the rupee-dollar rate,theprincipal exchangeratein the Indian in market the light of the PPP Theory. Such an examinationhas some importantpolicy implications.The TaraporeCommittee on Economic and Political Weekly Capital Account Convertibility has recommendedthat "the RBI should have a ExchangeRateBandof ?5.0 per Monitoring centaround NeutralREER." the Presumably, the neutralREER should relate to a period (the base period)when the exchange market is in equilibriumand PPP holds good. By...
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