Question

1. T or F? Explain! “A currency maintain its purchasing-power-parity if it depreciates by an amount equal to the excess of domestic inflation over foreign inflation.”   Give a numerical example.

Answer 1

Solution: TRUE

Explanation: The purchasing power parity theory (PPP) predicts that over the long run changes in relative national price levels determine changes in rates of exchange. Moreover the PPP approach asserts that a country’s currency rate of exchange would appreciate by an equal amount to the excess of foreign inflation over domestic inflation. Thus a currency maintains its PPP when it appreciates (depreciates) by an amount equal to the excess of foreign (domestic) inflation over domestic (foreign) inflation. For example the dollar must depreciate by 100%, i.e. from $0.50 per franc to $1 per franc for maintaining its PPP. Now if the rate of inflation doubles in Switzerland while rate of inflation remains unchanged in U.S. the dollar would appreciate at $0.25 per franc as per PPP theory