2. Relative purchasing power parity Aa Aa According to the law of one price, aft

Question

2. Relative purchasing power parity Aa Aa According to the law of one price, after adjusting for exchange rates, identical products should sell for same price in all countries. This relationship states that prices and exchange rates between two countries move to a level where a basket of goods will have the same price in the two countries. This form of law of one price is called: O Absolute purchasing power parity O Relative purchasing power parity Suppose you need to forecast the one-year forward rate between the euro and the U.S. dollar. Based on your research, you expect inflation in the eurozone to be 2.8% next year, whereas inflation in the United States is expected to remain at 1.4% in the coming year. The current spot rate between the two regions can be represented as $ 1 € 0.8008. Based on the information you have, your estimate of the one-year future spot rate-if you consider the United States as your home country-is Therefore, the higher inflation rate in the eurozone can be expected to lead to a decline in the future spot value of the euro relative to the dollar by The relative purchasing power parity is considered to be generally more useful for predicting movements in foreign exchange rates on a: O Short-term basis O Long-term basis

Explanation / Answer

Absolute purchasing power parity is the kind discussed in A Beginner's Guide toPurchasing Power Parity Theory (PPP Theory). Specifically, it implies that "a bundle of goods should cost the same in Canada and the United States once you take the exchange rate into account".

Relative purchasing power parity is an economic theory which predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period.

Answer : Absolute purchasing power parity

(1+ih)/(1+if) = f1/e0

ih = inflation rate in home country = 1.4%

if = inflation rate in foreign country = 2.8%

e0 = spot rate = $1 = euro 0.8008

f1 = future spot = ?

(1 + 1.4%)/(1 + 2.8%) = f1 / 0.8008

f1 = future spot = 0.7898

Decline by =  0.8008 - 0.7898 = 0.011

Decline by (%) = 0.011/0.8008 = 1.38%

a.PPP is not useful for predicting exchange rates on the short-term basis mainly because international commodity arbitrage is a time-consuming process.

b. PPP is more useful for predicting exchange rates on the long-term basis.

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