Question

6. Given a group of geographically close and similar countries that introduce a common currency and free trade agreements between group members, what would happen to inflation rates between these countries assuming Purchasing Power Parity (PPP) holds?

Answer 1

SOLUTION

INFLATION RATES BETWEEN COUNTRIES, ASSUMING PURCHASING POWER PARITY.

Purchasing power parity is an economic concept that seeks to weigh the value of one's country's dollar against another. This is done by visualizing a basket of goods and then comparing the cost of those goods in each country being measured. However you can't take a look at the price of one group of products in various countries. To get an accurate picture of purchasing power parity, you neec to compare a wide variety of products in that ''basket of goods''. The international Comparision program makes determining purchasing power parity its business. The organization strives to generate accurate purchasing power parities through a global survey that looks at the cost of numerous goods . Economists across the world look at this data when determining how the international economy is performing.

One reason purchasing power parity is so important is its influence on exchange rates and inflation rates. As with the U.S, other countries price items based on what the market will bear. If the economy is strong and the business can get away with changing more, they often will. Although PPP doesn't directly influence prices, it does show global experts how healthy global economies are. An important part of learning about PPP exchange rate is understanding how exchange rates work. Exchange rates are determined by money dealers who buy and sell local currencies. They set a buying rate, which is the price they will pay for foriegn currency, as well as the selling rate, which is the rate they will set that currency. Exchange rates not only ensure the dealer recoups his investmennt, but also can include an extra fee to make sure that the dealer makes profit. So, therefore, ''if a country has a relatively high inflation rate, the value of currency should decline''.