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Answer

Correct Option is 1 and 3 only

Concept: Purchasing power parity is used worldwide to compare the income levels in different countries. PPP
thus makes it easy to understand and interpret the data of each country.
The PPP theory aims to determine the adjustments needed to be made in the exchange rates of two currencies to
make them at par with the purchasing power of each other.
In other words, the expenditure on a similar commodity must be same in both currencies when accounted for
exchange rate. The purchasing power of each currency is determined in the process.
Justification: Suppose sandwich is the only good made in both India and USA.
• It costs Rs. 120 in India and $2 in USA.
• Suppose the rupee-dollar exchange rate is 60. If that is the case, then the market value of sandwich in
both nations in the same. You can buy the same amount of sandwich from 2 dollars as you can with 120
rupees.
• If sandwich was too cheap in India, say Rs. 50, then the two nations had different purchasing power.
• If income levels in both India and USA are same, a US national can actually buy less sandwiches than an
Indian national, as Sandwich is relatively costlier in USA than India.
Statement 2 and 3: In the above case, even though India and USA are at purchasing power parity, they need not
have equal exchange rates or equal forex reserves. They will have equal national income when measured in their
common currencies. You can see this from the example above. If all that USA and India made was sandwiches,
and if their prices were at PPP, then there is no reason for us not to believe that these nations produce goods of
equal value, and thus have equal national income.

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