supporse that the cost of a basket of goods purchased by a typical consumer over
ID: 1103535 • Letter: S
Question
supporse that the cost of a basket of goods purchased by a typical consumer over the course of a week in US is $1000. The cost of a basket of goods purchased by the typical consumer in UK over the course of a week in 1500 pounds. The current exchange rate is 0.5 dollar per pound = 0.5 dollar/pound
1. Identify two disctinct reasons why purchasing power parity might not hold between these two countries.
2. suppose tha the return (in pound) on a UK bond is 5%. The return (in dollar) on an equally risky the US bond is 2%. For both relative PPP and interest rate parity to hold, what must the expected rate of inflastion is UK be if the price level in the US is predicted to rise up to $1050 next year (from $1000 this year)?
Explanation / Answer
1. Identify two disctinct reasons why purchasing power parity might not hold between these two countries.
The current exchange rate is 0.5 dollar per pound. The cost of a basket of goods purchased by a typical consumer over the course of a week in US is $1000. So if someone has $1000 dollars, she can buy the basket in US, the sell the same in UK for 1500 pounds and because exchange rate is 0.5 dollar per pound, she can exchange 1500 pounds with $3000. So there is an arbitage opportunity to earn profit and secondly there will be transaction costs in transporting the basket. Hence PPP might not hold in this situation.
2. suppose tha the return (in pound) on a UK bond is 5%. The return (in dollar) on an equally risky the US bond is 2%. For both relative PPP and interest rate parity to hold, the expected depreciation of dollar in future is
2% = 5% + Expected depreciation of £/$
Hence £/$ exchange rate will appreciate by 3%.If the price level in the US is predicted to rise up to $1050 next year (from $1000 this year), there is a 5% inflation rate. Hence we have
growth rate of exchange rate £/$ = growth rate of $ - growth rate of £
3% = 5% - % change £
Hence, expected rate of deflation in UK will be 2% which is true because there will be an appreciation of pound.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.