Question

11. Canada’s inflation rate is 2% over one year but the inflation rate in the US is only 1%. According to PPP what should happen to the US dollar / Canadian dollar exchange rate?

A) The US dollar depreciates in the long run

B) The Canadian dollar depreciates in the long run

C) Inflation has no effect on the exchange rate in the long run

D) We cannot tell the effect of exchange rate in the long run without information about the interest rate in the two countries

E) We cannot determine the effect of the exchange rate without knowing whether the two countries are experiencing economic growth or not

Answer 1

B) The Canadian dollar depreciates in the long run

The reason is that inflation perpetuates depreciation in the sense that it is the increase in the price of domestic currency and so when nominal exchange rate is computed, we use the ratio of price of domestic currency to the price of foreign one. When domestic currency increases in price by more than the foreign one, inflation rate increases the value of curreny in terms of the other.

This can be seen in another way. Higher domestic prices reduce the foreign demand for domestic currency and so its value falls and price increases. Currency therefore depreciates. The relative depreciation is more focussed towards the currency that has a higher inflation.