Question

1.  Suppose that the price level in the United States is 135 and the price level in Germany is 234. What would absolute purchasing power parity theory predict the dollar/euro exchange rate to be?

2. If the United States rate of inflation is 2% and the German rate of inflation is 5%, what would relative purchasing power parity predict about the value of the euro relative to the dollar, all other things equal?

Answer 1

1.

The absolute purchasing power parity theory states that the price of the same set of goods in different countries will be same and hence the cost of living will also be same in these countries.

The dollar euro exchange rate can be calculated as

P=Pa/Pb

P---Exchange rate of two currencies

Pa---Price of a good a in one country

Pb---Price of same good in second country

Hence

P=135/234

P=0.5769 is the dollar euro exchange rate between two countries.

2.

The Relative Purchasing Power parity theory compare the exchange rate of two countries based on the inflation rate of these countries.Since according to this theory the higher the inflation rate of a given country the lower will be the value of money or purchasing power of that currency .As in the above question the inflation rate of US is 2% and that of Germany is 5%,which implies that the inflation is higher in Germany and thus with the same amount of currency people in Germany will be able to purchase less amount of goods as compared to people of USA if all other factors remains same.Thus higher the inflation rate in a country lower is the purchasing power of the currency relative to a country whose inflation rate is lower.