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2. The inflation rate in the USA is 5 percent while the inflation rate in Japan is 10 %. The current exchange rate for the Japanese yen () is $0.0075. After supply and demand for the Japanese yen have adjusted in the manner suggested by purchasing power parity, the new exchange rate for the yen will be? Briefly explain the PPP theory. 15 points
| 2] | ||
| a] | Per the PPP theory, the forward price = Spot*(1+domestic inflation rate)/(1+foreign inflation rate) = 0.0075*(1.05/1.1) = | $ 0.0072 |
| b] | According to this theory, rates of exchange between two countries are determined by relative price level. In other words, the rate of exchange should be such that the two currencies, when exchanged at that rate, | |
| should have the same purchasing power. | ||
| The PPP theory has two versions: | ||
| 1] Absolute PPP theory: | ||
| The theory states that at any point of time, the exchange rate | ||
| between two currencies, is the ratio of the amount of the currencies | ||
| paid for the same basket of goods. | ||
| Thus, if a basket of goods costs 10 dollars in USA and 5 GBP in Britain, | ||
| the exchange rate between the two currencies should be: | ||
| 1 GBP = 2USD. | ||
| 2] Relative PPP theory: | ||
| The relative version says that the change in the exchange rate over a | ||
| period of time should be proportional to the relative change in price | ||
| levels in the two countries during that period. | ||
| Thus, the future exchange rate should be: | ||
| Spot exchange rate*[1+inflation rate in the home country]/[1+inflation rate in the foreign country] |
