The concept - Purchasing power parity (PPP) - is an economic theory and a technique used to determine the relative value of currencies, estimating the amount of adjustment needed on the exchange rate between countries for it to be equivalent to (or on par with) each currency's purchasing power. Once PPP is determined, the movement between exchange rate is belived to be a function of thier relative inflation. Relative purchasing power parity (RPPP) relates the change in two countries' inflation rates to the change in their exchange rates. If a country has an annual inflation rate of 10 per cent, it's currency will be able to purchase 10 per cent less real goods at the end of one year. Relative purchasing power parity examines the relative changes in price levels between two countries and maintains that exchange rates will change to compensate for inflation differentials.
Assuming year 2002 as the base year (Base figure Rs 100 and exchange rate Rs 48.24), we have applied this theory to see how ruppee-dollar exchange rate should have behaved if this theory was to hold true.
In 2002, India's inflation was 4.39 per cent whereas USA's was 1.59 per cent. This implies INR compared to USD lost 2.76 per cent purchasing power in that year. Under RPPP theory, INR should depreciate 2.76 per cent against USD. Similarly, in 2003 INR should have depreciated further by 1.5 per cent. In similar fashion, the theoritical exchange rate has been calculated till year 2012 and the results are astonishing.
If the theory holds true, the real worth of ruppee in dollar terms is close to 73.62 as India on a cumulative basis saw its purchasing power getting erorded by a massive 52.6 per cent over and above that of US'.