Real Exchange Rate and Purchasing-Power Parity (PPP )

We always come across the question: How can we practically determine the real exchange rate?

It is done in the following way.

It is an exchange rate between two currencies calculated by valuing a given basket of goods and

Services in terms of the two currencies and dividing the two resulting sums. Suppose there is a

Per cent increase in prices in Britain, no inflation in Germany, and a 10 per cent depreciation of

The British currency against the Euro; then the real exchange rate between the pound and the Euro

Is constant. Let us see if the purchasing-power parity tells upon exchange rates. An exchange rate

Between two currencies such that the same basket of goods and services could be bought in each

country if the cost were converted at that exchange rate. For instance, if a loaf of bread cost ￡1 in

the UK and $2 in the USA, the purchasing-power parity exchange rate would be ￡1 to $2.

Market exchange rates are determined by a mix of forces and can fluctuate considerably. This

Makes accurate comparisons of international economies using market exchange rates difficult.

The use of purchasing-power parity is a preferred alternative, although not without its own problems

Of measurement. The World Bank (International Bank for Reconstruction and Development)