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Explain the basic difference between the exchange rate method and the purchasing power parity method of measuring national income, and explain the motivation for using the purchasing power parity method. Why do purchasing power parity measureas of income tend to show a smaller difference between low-income and high-income countries than other measures of income?

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Deanna Hettinger
Deanna HettingerLv2
9 Feb 2018
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Related questions

Looking at Venezuela, Germany, Samoa, and Saudi Arabia.

1. Are these countries under a flexible it fixed exchange rate system? What's the difference between the two systems.
2. Since last year, have these currencies appreciated or depreciated? Specific examples.
3. What is the effect of currency appreciation or depreciation on trade, i.e. import and export of goods and services? Use examples of one of the countries.
4.What is the Purchasing Power Parity? Explain with one example.
5. In few words, explain how foreign exchange arbitrage occur.

Mexican interest rates are normally substantially higher than U.S. interest rates. a. What does this imply about the inflation differential (Mexico inflation minus U.S. inflation), assuming that the peso interest rate is the same in both countries? Does this imply that the Mexican peso will appreciate or depreciate? Explain. b. It may be argued that the high Mexican interest rate should entice U.S. investors to invest in Mexican money market securities, which could cause the peso to appreciate. Reconcile this theory with your answer (a). If you believe that the high Mexican interest rate does not entice U.S. investors, explain why. c. Assume that the difference between Mexican and U.S. interest rates is typically attributed to a difference in expected inflation in the two countries. Also, assume that purchasing power parity holds. Do you think that your business cash flows would be adversely affected? In reality, purchasing power parity does not hold consistently. Assume that the inflation differential (Mexico inflation minus U.S. inflation) is not fully offset by the exchange rate movement of the peso. Would this benefit or hurt your business? Now assume that the inflation differential is more than offset by the exchange rate movement of the peso. Would this benefit or hurt your business?

Problem 3

3.1. Suppose quotes for the dollar-euro exchange rate E$=e are as follows: in New York

$1.50 per euro, and in Tokyo $1.55 per euro. Describe how investors use arbitrage to take advantage of the difference in exchange rates. Explain how this process will affect the dollar price of the euro in New York and Tokyo.

3.2. What is covered interest rate parity?

3.3. What is uncovered interest rate parity?

3.4. Consider some good g that sells in the U.S. and Europe. What is the relative price of this good?

3.5. What is the law of one price, and if it holds, what should be true about the relative price of good g in (3.4)?

3.6. Consider a basket of goods in the U.S. and Europe. Given these baskets, determine the real exchange rate.

3.7. What is purchasing power parity, and if it holds, what would be true about the real exchange rate in (3.6)?

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