A television costs US dollar ($) 1,000 in United States. The same television costs Nepalese rupees (NPR) 133,330 in Nepal. If purchasing power parity holds, what is the spot exchange rate between…

Spot Exchange Rate Calculation Using Purchasing Power Parity (PPP)

Purchasing Power Parity (PPP) states that the exchange rate between two currencies should adjust so that the same basket of goods costs the same in both countries. Here, we use the Law of One Price (LOOP), a simplified form of PPP, to determine the equilibrium exchange rate between the US dollar (USD) and Nepalese rupees (NPR).

Given:

• Price of TV in the US = $1,000
• Price of the same TV in Nepal = NPR 133,330

Step 1: Apply the Law of One Price

Under PPP, the exchange rate $E$ (NPR per USD) should satisfy: $$E=\frac{\text{Price in NPR}}{\text{Price in USD}}$$

Step 2: Calculate the Spot Exchange Rate

$$E=\frac{133,330}{1,000}=133.33\text{ NPR/USD}$$

Thus, the spot exchange rate under PPP is 133.33 NPR per USD.

Interpretation of the Result

1. Equilibrium Exchange Rate: The calculated rate (133.33 NPR/USD) represents the theoretical equilibrium where no arbitrage opportunities exist. If the actual market exchange rate deviates significantly from this, traders may exploit price differences.
2. Relative Purchasing Power:
   • If the actual exchange rate is lower than 133.33 NPR/USD, Nepalese goods become cheaper for foreigners, and USD appreciates against NPR.
   • If the actual rate is higher than 133.33 NPR/USD, Nepalese goods become more expensive, and NPR depreciates.
3. Inflation & Economic Conditions:
   • If Nepal’s inflation is higher than the US, PPP predicts NPR should depreciate over time.
   • If the actual rate is above 133.33, it may indicate trade barriers, non-traded goods, or capital controls in Nepal.
4. Policy Implications:
   • A persistent deviation from PPP suggests misalignment in currency valuation, which may affect imports/exports.
   • Central banks (like Nepal Rastra Bank) may intervene to stabilize the exchange rate if deviations are extreme.

Limitations of PPP in This Context

• Assumes no trade barriers (tariffs, quotas) and perfect arbitrage.
• Ignores transport costs, taxes, and non-traded services.
• Works best for traded goods (like electronics) rather than services or unique products.

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Final Answer: The spot exchange rate under PPP is 133.33 NPR per USD. This implies that, in equilibrium, one US dollar should exchange for 133.33 Nepalese rupees to maintain equal purchasing power for the same television in both countries. Deviations from this rate may indicate economic imbalances, inflation differences, or market inefficiencies.