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Purchasing power parity and exchange rate

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5. From the base price level of 100 in 1974, German and U.S. price levels in 2001 stood at 200 and 370, respectively. If the 1974 $/DM exchange rate was $0.23/DM, what should the exchange rate be in 2001?

Suggestion: Using the purchasing power parity, adjust the exchange rate to compensate for inflation. That is, determine the relative rate of inflation between the United States and Germany and multiply this times $/DM of .23.

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Solution Summary

Purchasing power parity is used to calculate the exchange rate.

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Exchange rate in 2001 / Exchange rate in 1974= US inflation/ German inflation

Exchange rate in 2001 / $0.23/DM = 370/ ...

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