The Purchasing Power of Everything: Factors that influence

Hundred Dollars put under the mattress in the year 1977 if taken out today will not remain the same hundred dollars as what you could buy with it now would be a fraction of what you could in 1977. The Rupee equivalent of hundred dollars in 1977, which was Rs.750 similarly, is now Rs.7200 and what you could do with Rs.750 in 1977 you can hardly imagine doing anything seriously worth now, although if you would have waited to convert the dollar into Rupee now it would be worth almost ten times (Rs.7200) of what this conversion would have yielded in 1977.

This aberration is partly explained by the Purchasing Power of currency, our Rupee in 1977 could buy a basket of goods but that basket has surely shrunk. The dollar similarly in its purchasing power has shrunk over such a long period, but the relative strength of the rupee against the dollar has shrunk several times, which is worth a little more enquiry.

The first factor which has contributed to this is inflation and the relative inflationary forces between these two economies, India and U.S. tells the story. While India has gone through its spirals of inflation in the period from 1977 to 2018, touching doubling digits as certain periods of time and then now being tamed in low single digits, similar is the denouement in U.S. as well albeit at a more modest rate.

Taming inflation is so fundamental to the purchasing power of the currency that this becomes the central point of Central bank posturing on the exchange rate. This brings us to the second factor in our enquiry, which is the interest rate.

When interest rates have been used to tame inflation, it stabilized inflation for sure over time, but it also impacted the exchange rate. If there is a differential between the interest rates in two countries there is always an opportunity to invest and simply benefit from the interest rate differential. This makes allowance for currency flows into an economy and outflow as well. Both these flows would impact the exchange rate. When you have shortage of dollars in your economy you will go out to buy more and your exchange rate will fall therefore.

The third factor, which gets ignored the most is the trade balances. If you are running a trade deficit you will always run short of dollars you need for your buying of inputs that gets traded in dollars.

India’s trade as a percentage of global trade is minuscule 1.6%, which shows also the relative strength of our economy vis-a-vis other nations on trade. Well, you could potentially not need to trade if you are self-sufficient, but even self-sufficiency would need you to compete with others and that can only happen through trade.

For competitiveness of your industries, you must trade with others to be able to learn where your gaps are and where you are stronger than the others. The relative strength of Rupee against a basket of currencies can also be proved to be a reflection of the relative competitiveness in the trade front, that allows you to balance your external account.

The Rupee will keep depreciating with inflation and for a growing economy like India, it will depreciate more than the other economies. The only question to be looked as whether the real income of people are growing at a rate that is better than this. If real incomes (which factors the inflation) grow at a healthy rate, there is no reason to worry on inflation. But this tells part of the story.

No economy can think of itself in isolation, surviving on its own, with its own intrinsic strength. Each and every commodity and finished goods it makes can be traded. The domestic price therefore is a reflection of the relative strength of the economy to withstand the marauding influence of an external trade partner trying to enter its economy. This is usually balanced by the tariffs. The same is true for your own industries who want to export its competitiveness as well.

If tariffs move up, it is a relative weakness of your economy, not strength. The protection you provide is a reminder that you are raising the price of goods, which thereby raises inflation.

Tariffs therefore is the fourth factor in our inquiry and is a defensive posture for the economy.