Question

2. Assume that purchasing power parity holds real exchange rates close to E(f/d) = 1. Suppose:

a. The nom exchange rate e(EUR/CAD) is decreasing. Where is inflation higher?___________

b. The nom exchange rate e(GBP/CAD) is increasing. Where is inflation higher?____________

c. Using the information in a and b, where is inflation highest? Europe or Canada or Great Britain

Answer 1

ans.....
- a) - The nominal exchange rate is increasing, thus, 1 EUR can buy more JPY as compared to earlier. That means, more amount of JPY is needed to buy the same basket of goods than EUR. Thus, inflation is increasing in JPY. Therefore, Inflation is higher in JPY
- b) - The nominal exchange rate is decreasing, thus, 1 CAD can buy less JPY as compared to earlier. That means, less amount of JPY is needed to buy the same basket of goods than CAD. Thus, inflation is increasing in CAD. Therefore, Inflation is increasing in CAD
- c) - Comparing all 3, we get that Inflation is higher in JPY as compared to EUR, but inflation is higher in CAD as compared to JPY. Thus, inflation is highest in CAD