Question

Please describe the impact of positive and negative productivity shocks on the foreign exchange rate according to purchasing power parity (You can use PPP for this question) .

Answer 1

A negative productivity shock leads to a decrease in supply. Thus, the supply shifts to the left, and the economy will have rising prices. Now the purchasing power parity theory tells us that in order for two countries to have equilibrium exchange rates (equal purchasing power), a rise in prices in a country is accompanied by the depreciation of the currency. Thus, the country facing a negative productivity shock will see a depreciating currency.

Similarly, if there is a positive productivity shock, the supply increases, inflation falls and the country will face an appreciating currency.