Prepare a short (around10 pages long) research paper on one of the following topics: 1. Trade Policy of …. (a country of your choice) 2. Exchange Rate Policy of … (a country of your choice) 3....

Purchasing Power Parity and Exchange Rate in India
Abstract
The paper presents the test of purchasing power parity of. It uses annual data of the real exchange rate from USDA from the period 1970-2012. The purchasing power parity is tested using ADF, PP, DFGLS and KPSS unit root tests. The results fail to reject the null of unit root for real exchange rate which towards the failure of PPP in India.
Introduction
The exchange rate sometimes known as foreign exchange rate or forex rate is the rate at which the currency of an economy that is exchanged for another currency. It is one of the key macroeconomic variables of an economy and is regarded as the value of one country’s currency in terms of another currency. It plays an important role as it is an key instrument in the decision making process for the foreign exchange investors, exporters, importers, bankers, businesses, financial institutions, policymakers and tourists across the nations. Our daily life is hugely impacted by the exchange rate of our currency in today’s integrated world.
Following the economic reforms of 1991-93, India began to appear as a player of some significance in the global economy. In this light the exchange rate policy of India is not only of the importance to the people of India but it has global implications. In this paper I want to discuss about the validity of Purchasing Power Parity (PPP) theory in the Indian economy using real exchange rate data by employing empirical econometrics modeling.
Brief History of India’s Exchange Rate:
Before the reforms in Indian economy, the exchange rate market in India was highly regulated. From the period after the independence in 1947 until the end of 1973, India used to follow an exchange rate regime where Indian Rupee was linked to the Pound Sterling (except for the devaluations in 1966 and 1971). The link with the Pound Sterling was served on September 24, 1975 and India initiated the managed float exchange regime where India Rupee was managed on a on a controlled, floating basis and at the same time it was linked to a “basket of currencies” of India’s major trading partners. This policy continued until the initiation of the reforms process in the 1990’s’.
In the early 1990’s India faced with a difficult economic situation combined with a huge trade deficit which led the central bank of India or the Reserve Bank of India (RBI) to undertake downward adjustment of Rupee in 1991. Consequently RBI introduced the Liberalized Exchange Rate Management System (LERMS) in March 1992 which was characterized by a system where the exchange was determined by RBI as well as through market mechanism. However, this dual mechanism of exchange rate determination was replaced with the singles system of market determined exchange rate in March 1993. It is important to note here that even today, the exchange rate policy of India does not allow the rupee to appreciate freely in line with market trends, or to depreciate significantly, nor does it target its “calculated volatility”. In the words of the former Governor of the RBI, “the RBI does not have a fixed “target” for the exchange rate which it tries to defend or pursue over time; the RBI is prepared to intervene in the market to dampen excessive volatility as and when necessary…….”(Jalan, 2003). RBI intervenes in the market through buying and selling of foreign currencies and also employs monetary policy in order to maintain stability in the exchange rate market. s
Previous Literature about PPP
Purchasing Power Parity (PPP) is an economic theory which states that if purchasing power is same in two countries then the exchange rates between those two countries’ currencies are in equilibrium. In other words, the exchange rate between two countries should equal the ratio of the price levels of a fixed basket of goods and services. Purchasing power parity is simply the application of the law of one price at the national price levels of goods and services. It suggests that the changes in the relative national price level between two countries determine the changes in the exchange rate over the long run period, that is, foreign exchange value of a currency appreciates or depreciates at a rate equal to the difference between foreign and domestic inflation. One of the key implications of the PPP hypothesis is that the real exchange rate should be stationary, that is any shock to the real exchange rate (RER) is temporary or short-lived and in the long run the real exchange will revert to its mean value as the relative prices will move in proportion to the change in the nominal exchange rate (McDonald, 1996; Wu, 1996). A non-stationary PPP cannot be used to determine the equilibrium exchange rate, which invalidates PPP and in turn the monetary approach to exchange rate...