What is Absolute Purchasing Power Parity (APPP) and what is Relative Purchasing

Question

What is Absolute Purchasing Power Parity (APPP) and what is Relative Purchasing Power Parity (RPPP)? Now, consider the following: The inflation rate in the US is projected at 5% per year for the next 4 years. The Australian inflation rate is projected to be 3% during that time. Currently, the spot rate is Australian Dollars, (AD$ 1.35/1US$) - European Quote. Based on relative Purchasing Power Parity (RPPP), what is the expected exchange rate in 4 years for the Australian Dollar (AD) vs. the US Dollar?

Explanation / Answer

Purchasing Power Parity (PPP) states that exchange rates between different currencies are in equilibrium when their purchasing power is the same in two countries. This means that the exchange rate between two countries should equal to the ratio of the two countries' relative price levels. If the price level of one country increases (i.e. the country experiences inflation), its currency must depreciate in order to maintain PPP.

Absolute PPP refers to the equalization of real price levels across countries. Relative PPP holds that the percentage change in exchange rates, over any period, equals the difference in the percentage price changes of different countries. It refers to the equalization of real price changes across countries. Absolute PPP implies relative PPP, but the converse is not true.

what is the expected exchange rate in 4 years for the Australian Dollar (AD) vs. the US Dollar

Australian inflation rate projected to be 3% and Inflation rate in US is projected to be 5%. It means there will be 2% per annum appreciation in australian dollar in compare to US dollar .So in four year australian dollar will appreciate by 8% in compare to US dollar.

Expected exchange rate in 4 year=(AD$ 1.35/1US$)*(100-8)%

Appreciated Expected exchange rate in 4 year=1.35*92%=AD$1.242/1US$

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