Question

1. Answer the following questions regarding International Finance.

   1. What do we mean by ‘Purchasing Power Parity’? Explain.

   2. A beer in the United States sells for $4. The same beer can sell for €3 in France. The current nominal exchange rate is $1.08/€. Calculate the real exchange rate of the French beer per US beer (use two decimal points). Based on your response, is beer relatively more expensive in the US or in France? Show your work and explain.

   3. Use the market for foreign exchange to analyze the effect of the following events. In your graph, make sure to identify the effect of each of these events on the US dollar (i.e. does the dollar get weaker/stronger?) Explain in 1-2 sentences what each of your graphs is showing. Important: Treat each event separately (i.e. draw a separate graph for each event).

      1. American companies discover a new technology that allows them to become much more productive.

      2. The Central Bank of Canada decides to raise their interest rates.

Answer 1

1) Purchasing power parity is metric that is used to compare the currency value through its purchasing power by using a basket of goods and services. It actually helps in measuring the cost of goods and services and compare it with other countries in the world. There are two versions of purchasing power parity, relative purchasing power arity and absolute purchasing power parity. The relative PPP says that exchange rate equals the price ratio level between two countries while the absolute PPP states that the exchange rate should indicate the price ratio level between two countries similar basket of goods and services.