Harish Damodaran

Inflation, exchange rates and PPP

Harish Damodaran | Updated on March 22, 2011 Published on March 16, 2011

An interesting perspective on inflation: The FinanceMinister, Mr Pranab Mukherjee, with the Economic Surveyfor 2010-11   -  Rajeev Bhatt, The Hindu

Kaushik Basu offers an interesting theory of inflation linked to purchasing power parity catch-up in the latest Economic Survey.

The Economic Survey is normally a bland document written in typical boring sarkari English. Leave alone stimulating the mind, it offers little new by way of information: Much of its data on national income, inflation, industrial production, money supply, balance of payments or crop output estimates are already in the public domain at the time of publication.

The last couple of Surveys have, mercifully, delivered some respite from this dreary tradition, thanks largely to Dr Kaushik Basu's induction as Chief Economic Adviser in the Finance Ministry.

The Cornell University Professor has left his distinct imprint on both quality as well as overall drafting style – noticeable particularly in Chapter 2 of the 2009-10 and the latest 2010-11 editions.

Adjusting for parity

This time's Chapter 2 discusses, among other things, the concept of ‘PPP catch-up inflation' (p. 27). Now, the idea of PPP or purchasing power parity per se is simple. A $ 100 note is exchangeable today at around Rs 4,500. But with Rs 4,500, you can buy more goods and services in India than with $100 in the US.

Therefore, India's GDP expressed in dollars at current exchange rates is lower than what it would be when adjusted for PPP, i.e. the exchange rate reflecting a currency's effective local buying power.

The Survey estimates India's PPP correction factor at 2.9, meaning the stuff available here for $100 will cost $290 in the US. That corresponds to an exchange rate of roughly Rs 15.5 to the dollar. But the interesting bit is about the linkage with GDP. Countries with per capita GDP of $1,000-1,400 in 2009 – which include India, Pakistan and Vietnam — have an average PPP adjustment factor of 2.3.

In comparison, those with per capita GDP (unadjusted for PPP) between $8,000-12,000 — the likes of Brazil, Mexico, Russia and Turkey – require a correction of only 1.6 or thereabouts.

From this follows the conclusion that as economies grow, the required PPP adjustment also falls. Thus, India currently has a per capita GDP of $1,300 with a PPP correction of 2.9.

If the present high growth rates continue, its per capita GDP would touch $10,000 in 2039. By then, its PPP correction factor, too, would have dropped to 1.6, implying that the same basket of commodities costing $290 in the US (assuming no inflation there) will now be available here for $181, as against the earlier $100 level.

The fall in the PPP adjustment factor from 2.9 to 1.6 by 2039, in turn, entails either (a) an appreciation of the rupee to Rs 24.9 to the dollar or, (b) prices in India rising cumulatively by 81 per cent or 2 per cent per annum in constant dollars or, (c) a combination of both. Assuming three-fourths of the reduction to happen via (b), it would translate into an average annual dollar price inflation of 1.5 per cent in India. And that is what the Survey (more precisely, Dr Basu) calls ‘PPP catch-up inflation'.

Elegant though this formulation is — as is to be expected from our erudite Professor — it is not without flaws.

The order of catch-up

The main problem has to do with the direction of causality. Does inflation result from PPP levels aligning themselves closer to market-determined exchange rates? Or, is it just the other way round, wherein inflation is a cause rather than effect of PPP catch-up? The Basu formulation — an adaptation of the so-called Balassa-Samuelson effect — seemingly presumes PPP catch-up to be the causal variable, which necessarily engenders inflation.

To quote from the Survey: “…due to this apparent fall in the PPP correction factor, there would be some increase in prices…(The country) would face an inflation of 2 per cent per annum solely on account of this PPP adjustment”.

In the real world, however, things probably work in the reverse. As inflation erodes the rupee's domestic purchasing power, the basket of goods and services that can be bought with Rs 4,500 will shrink over time. Assuming no corresponding depreciation of the rupee, domestic prices would increasingly approach global levels.

In the process, the PPP exchange rate is driven nearer to the market-determined exchange rate. We are, in other words, talking of ‘inflation catch-up PPP' as opposed to ‘PPP catch-up inflation'!

Lamb vs. Tiger

The phenomenon of ‘inflation catch-up PPP' can be seen in India, where the rupee has, over the years, emerged as a ‘lamb' at home and a ‘tiger' abroad. Since 2004-05, it has depreciated by hardly 4 per cent against the dollar, which is way below the 46 per cent rise in the all-commodities wholesale price index.

When sustained inflation is accompanied by high growth, which attracts capital inflows and prevents countervailing depreciation of the local currency, it may eventually lead to Rs 4,500 having just as much purchasing power in India as $100 would in the US.

A case of PPP, and not inflation, catching up.

Published on March 16, 2011
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