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Q. Assume a basket that costs $100 in the U.S. would cost $120 in the United...

Q. Assume a basket that costs $100 in the U.S. would cost $120 in the United Kingdom. (18 pts)

a) What is the U.S. real exchange rate, qUS/UK, with the United Kingdom? Intuitively, what does this real exchange rate imply? (5 pts)

b) Does PPP hold true here? Why? (5 pts)

c) Instead, let’s assume that a basket that costs $100 in the U.S. would cost also $100 in the United Kingdom. For the next year, the Fed is predicted to keep U.S. inflation at 2% and the Bank of England is predicted to keep U.K. inflation at 3%. Does PPP hold true here? If so, use relative PPP to predict what will happen to the dollar’s value against the poundin one year’s time. (8 pts)

Solutions

Expert Solution

Hi,

Hope you are doing well!

Question:

Answer:

a). Answer:

A basket that costs $100 in the U.S

A basket cost $120 in the United Kingdom.

Exchange rate (USA/UK) = ?

I will calculate it by the PPP method.

PPP = Cost of basket in currency 1/Cost of basket in currency 2

= 120/100 = 1.20

USA/UK = 1.2000

In the real world the GBP is more costlier than USD. The nominal exchange rate of USD/GBP = 0.78

But because of of higher cost of basket in the United Kingdom make it less costlier than USD. Purchasing power parity (PPP) allows for economists to compare economic productivity and standards of living between countries.

b). Answer:

In the real world the GBP is more costlier than USD. The nominal exchange rate of USD/GBP = 0.78

But because of of higher cost of basket in the United Kingdom make it less costlier than USD. Purchasing power parity (PPP) allows for economists to compare economic productivity and standards of living between countries.

But PPP does not hold true because its not include the transportation cost, duties and taxes. Exchange arte may be different because of different economic health, consumer behavior and other social factors.

c). Answer:

A basket that costs $100 in the U.S.

A basket that cost also $100 in the United Kingdom.

Predicted inflation in UK = 3%

Predicted inflation in USA = 2%

A new cost of basket in USA = 102

A new cost of basket in UK = 103

PPP = 103/102 = 1.0098

USA/UK = 1.0098

Dollar will be depreciated after one year because current exchange rate is USA/UK = 1.2000 and exchange rate after one year will be USA/UK = 1.0098.

But PPP does not hold true because its not include the transportation cost, duties and taxes. Exchange arte may be different because of different economic health, consumer behavior and other social factors.

Thank You

Rahul Sunny answered 2 years ago
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