Question

QUESTION TWO a) What is the difference between Absolute Purchasing Power Parity (APPP) and Relative Purchasing Power Parity (RPPP)? (5 Marks) b) Consider a world that only co mprises 3 goods (Good 1, Good 2, Good 3) and 2 countries (Fra nce and Japan). A (0.50, 0.25,0.25). ssume that consumption weights of these goods for both countries be The price of the goods at time t are listed below- France EUR) Japan(Yen) 20 40 80 60 Good 1 Good 2 Good 3 150 i) For each good, what exchange rate is consistent with the law of one price? (2 Marks) CONTINUED BE630-6-SP/3 i) Let the spot exchange rate at time t be equal to 0.50 EUR per Yen. Does absolute purchasing power parity (PPP) hold between the France and Japan? (3 Marks) c) You are now given the following time+1 information: France(EUR) Japan(Yen) Good Good 2 40 100 190 50 90 70 Good 3 Using the information in (b), what spot exchange rate at time t+1 does relative purchasing power parity (PPP) imply? (5 Marks) ITOTAL-15 MARKS

Answer 1

a) relative purchasing parity is an economic theory which predicts the relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period. It is dynamic. The theory of absolute purchasing power parity assumes that the equilibrium in the exchange rate between two currencies will force their purchasing power to be equal. This theory is likely to hold well for commodities which are easily transportable between the two countries but is likely to be false for other goods and services which cant be easily be transferred.