Question

(a) Explain why the theory of purchasing power parity cannot fully explain exchange rate. ( 8 marks)

(b) How do the expected returns on domestic and foreign deposits affect the short-run exchange rate? Explain in terms of interest parity condition

(c) How does exchange rate overshooting affect the volatility of exchange rte? ( 5 marks)

Answer 1

A: The purchasing power parity theory extends the law of one price to total economies. PPP states that exchange rates should adjust to reflect changes in the price levels between two countries. PPP may fail to fully explain exchange rates because goods are not identical, and price levels include traded and nontraded goods and services. Long-run exchange rates are determined by domestic price levels relative to foreign price levels, trade barriers, import and export demand, and productivity. Thus PPP can not be solely used as a measure to explain exchange rate. Also difference in monetary policy acros nations is a significant factor impacting exchange rate.