What is the PPP exchange rate?
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What is the implication for the real exchange rate if the PPP condition holds?
Under what circumstances does the PPP theory explain how exchange rates are determined.
why is it not completely accurate all the time?
Answer the following questions related to the predictions of PPP:
(a) What are the predictions of the PPP theory regarding real exchange rates?
(b) Discuss why the empirical support for PPP and the law of one price is weak in recent data.
Large-scale wars typically bring a suspension of international trading and financial activities. Exchange rates lose much of their relevance under these conditions, but once the war is over, governments wishing to fix exchange rates face the problem of deciding what the new rates should be. The PPP theory has often been applied to this problem of postwar exchange rate realignment. Imagine that you are a British Chancellor of the Exchequer and that World War I has just ended. Explain how you would figure out the dollar/pound exchange rate implied by PPP. When might it be a bad idea to use the PPP theory in this way?