Financial

Q4(p. 165)

Explain purchasing power parity, both the absolute and relative versions. What causes deviations from purchasing power parity?

The absolute version of purchasing power parity (PPP): S = P$/P£.

The relative version is: e=$ -£.

PPP can be violated if there are barriers to international trade or if people in different countries have different consumption taste. PPP is the law of one price applied to a standard consumption basket.

Q5(P.166)

Discuss the implications of the deviations from purchasing power parity for countries’ competitive positions in the world markets.

If exchange rate changes satisfy PPP, competitive positions of countries will remain unaffected following exchange rate changes. Otherwise, exchange rate changes will affect relative competitiveness of countries. If a country’s currency appreciates (depreciates) by more than is warranted by PPP, that will hurt (strengthen) the country’s competitive position in the world market.

Q10

Explain the following three concepts of PPP: The law of one price, Absolute PPP, Relative PPP.

The law of one price (LOP) refers to the international arbitrage condition for the standard consumption basket. LOP requires that the consumption basket should be selling for the same price in a given currency across countries.

b. Absolute PPP holds that the price level in a country is equal to the price level in another country times the exchange rate between the two countries.

c. Relative PPP holds that the rate of exchange rate change between a pair of countries is about equal to the difference in inflation rates of the two countries.

Q11

Evaluate the usefulness of relative PPP in predicting movements in foreign exchange rates on: short-term basis(for example, three months), Long-term basis(for example, six years).

a. PPP is not useful for predicting exchange rates on the short-term basis mainly because

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