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Purchasing Power Parity

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The Purchasing Power Parity Relative to Import/Export Rate.

Purchasing power parity (PPP) is after adjusting the exchange rates, similar goods would cost the same in different countries (Brigham & Houston, 2007). For example, a $2 chips in the United States may cost $8 pa'anga in Tonga. This means that PPP implies that the exchange rate is $2/$8 = $0.25 per pa'anga. PPP assumes that there are no transportation and transaction costs, or import restrictions, which is one shortage of the PPP since these assumptions do not occur in reality. Moreover, the $2 chips (could be Doritos or sun chips) in the U.S. may not be in Tonga as is always the case. However, PPP is useful when forecasting future situations.

The University of British Columbia (2008) stated, "Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries" (¶ 1). This means that the goods ...

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This solution is comprised of detailed explanation of purchasing power parity and how it relates to import and export. The referenced article is also attached in this solution.

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Interest rate parity and Purchasing power parity: forward contract amount

1. Implication of IRP. Assume that interest rate parity exists. You expect that the one-year nominal interest rate in the U.S. is 7%, while the one-year nominal interest rate in Australia is 11%. The spot rate of the Australian dollar is $.60. You will need 10 million Australian dollars in one year. Today, you purchase a one-year forward contract in Australian dollars. How many U.S. dollars will you need in one year to fulfill your forward contract?

2. Implication of PPP. Today's spot rate of the Mexican peso is $.10. Assume that purchasing power parity holds. The U.S. inflation rate over this year is expected to be 7%, while the Mexican inflation over this year is expected to be 3%. Wake Forest Co. plans to import from Mexico and will need 20 million Mexican pesos in one year. Determine the expected amount of dollars to be paid by the Wake Forest Co. for the pesos in one year.

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