In: Economics
Assume Purchasing Power Parity (PPP) holds in the long run between the U.S. and Europe. What does this already imply for the exchange rate E_($/€)? Write down your answer in the form of an equation and a brief explanation. (2 pts)
Now assume we have PPP and also that the quantity theory of money holds, with the velocity of money V constant and real output Y fixed and constant in both countries. Suppose that the Federal Reserve is expanding the supply of dollars by 5% per year, while the European Central Bank is expanding the supply of euros at 2% a year. What will happen to E_($/€) over time? Give a quantitative answer and a brief explanation. (2 pts)