Exercise Set 8
PURCHASING POWER PARITY

I. Objectives

1. To understand the Law of One Price
2. To compute the long-run exchange rate under PPP
3. To see how changes in inflation rates affect currency values

II. Data

• Input the data for the price level in the U.S. and the $/£ exchange rate.
• Compute the price level in UK that is consistent with PPP. Click on Gimme PPP! to confirm.
• Input the data for the inflation rates in the U.S. and UK.
• Compute the expected rate of depreciation of the dollar. Click on Gimme Relative PPP! to confirm.

III. Questions

1. Use the Bureau of Economic Analysis web site and the Economist to obtain the following data:
   • P_US = __________

   • E_$/£ = __________

   • Inflation rate in the U.S. = __________

   • Inflation rate in UK = __________

2. For absolute PPP to hold, the price level in Germany must be __________. Explain.

3. If relative PPP holds, the dollar is expected to [ depreciate / appreciate ] by __________ %. Explain.

4. Suppose the price level in the U.S. is 120, the price level in UK is 80 and the exchange rate is $1.60/£.
   
   
   • Based on the PPP idea, one might conclude that the pound is [ overvalued / undervalued ] relative to the dollar. Explain.
     
     
   • George Soros, the famous (or infamous?) currency speculator, believes that the current state of [ undervaluation / overvaluation ] of the pound will not last for long, and that the exchange rate will adjust to bring about PPP. In order to make profits through currency speculation, Soros will [ sell / buy ] pounds in the spot market at $1.60/£, and [ buy / sell ] pounds when (if?) the exchange rate reaches its PPP level at $______/£. Explain each step.

5. Explain why PPP may not hold, especially in the short run.