Discuss the difference between absolute and relative purchasing power parity (PPP) using the dollar per euro exchange rate and starting at $1.40/€1 and simple numerical examples. To illustrate absolute PPP concept use a price of the iphone in dollars (you make up the price in dollars) and euros (you make up the price in euros) and discuss what happens of the exchange rate deviates from the absolute PPP rate.
The absolute PPP theory states the same item( eg . an iphone) will cost the same in both the countries
after converting on currency to another. If an iphone costs $ 14 in the US. the it will cost 10 Euros (14/1.4) as the exchange rate is 1Euro = $ 1.40.
The relative PPP theory relates the changes in exchange rates to the changes in inflation rates between two countries. If the infation rate is higher in one country as compared to the another its currency will depreciate as compared to the other country's currency.
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