9. Problems and Applications Q9 Purchasing-power parity holds between the nation
ID: 2440876 • Letter: 9
Question
9. Problems and Applications Q9 Purchasing-power parity holds between the nations of Ectenia and Wiknam, where the only commodity is Spam. In 2015, a can of Spam cost3 dollars in Ectenia and 27 pesos in Wiknam. The exchange rate between Ectenian dollars and Wiknamian pesos was pesos per dollar Over the next 14 years, inflation is expected to be 5 percent per year in Ectenia and 10 percent per year in Wiknam. If this inflation comes to pass, what will happen over this period to the price of Spam and the exchange rate? ? , and the price of Spam in Wiknam will (Hint: Recall the rule of Over this period, the price of Spam in Ectenia will 70 from Chapter 27.) The exchange rate between the two countries will True or False: Wiknam will likely have a higher nominal interest rate. True OFalseExplanation / Answer
a)Since purchasing power parity holds,the exchange rate will be 3/27=1/9 dollars/peso. It means 9 pesos/dollar.
b) Using the Rule of 70,the prices in Ectenia will double in 70/5 = 14 years. Whereas,the prices in Wiknam will double in 70/10 = 7 years.So, over 14 years,prices in Ectenia will double once and prices in Wiknam will double twice.
After 14 years,the exchange rate will have to be adjust in order for PPP to still hold so that the price of spam is still same in terms of dollars in both the countries. Using the rule of 70, the price in Ectania after twenty years will be 3 X 2=6 and in Wiknam,it will be 27 x 4=108.
The exchange rate will be 108/6 = 18
c) Nominal Rate= Real interest rate + inflation rate. If PPP holds then the real interest rate will be equal between the two countries. So, Wiknam will have a higher nominal interest rate because of it's high inflation rate.
d) PPP implies that the real interest rates between the two countries will be the same. So, the nominal interest rate differential is offset by inflation and by change in the exchange rates. The get rich scheme would only work if there were a difference in real interest rates.The nominal exchange rate between two countries will adjust for the effects of inflation.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.