Question

If the U.S. inflation is 5% and the U.K. inflation is 3%, what can you infer from relative purchasing power parity (relative PPP) about the change in the exchange rate between the U.S. dollar and the British pound?

a. the pound depreciates against the dollar by 2%. 


b. the pound appreciates against the dollar by 2%. 


c. there is no change in the exchange rate between the dollar and the pound. 


d. the pound depreciates against the dollar by 8%. 


Answer 1

Purchasing Power parity states that the exchange rate between the two countries reflectes the therelative purchasing power of the two countries.That means price if the same object of two different countries should be equal when measured in a common currency.

When the Inflation rate in one country is higher than the other country than the value of  that country currency will depreciate with the equal amount and vice verse. to nullify the effect of increased inflation rate by decreased currency value.

Hence , here the inflation rate of pound is less than the inflation rate of US by 2% .so according to PPP theory Pound will appreciate against the dollar by 2%

Ans is b. the pound appreciates against the dollar by 2%