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    purchasing power parity

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    Consider two open economies A (national) and B.

    In this economy only one good is produced for time t = 0 and price P(0,A)=1 Dollar and P(0,B) = 1,5 Euro. The nominal exchange rate for that time is E(0)=1,5 Euro/Dollar.

    Country A has inflation of (A) = 10%
    Country B has inflation of (B) = 5%

    To which value the nominal exchange rate turns itself at time t = 1, assuming we have the absolute (Purchasing Power Parity)?

    1) E(1) = 0.75Euro/Dollar
    2) E(1) = 0.70Euro/Dollar
    3) E(1) = 3Euro/Dollar
    4) E(1) = 1,43Euro/Dollar
    5) E(1) = 1Euro/Dollar

    Please show the way to calculate it.

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    Solution Preview

    If inflation in A is 10%, then at t = 1, the price of the good in A will be 1*1.1 = $1.1. Thus, the new price is a 10% increase over the old price of $1.

    If ...

    Solution Summary

    Exchange Rate is integrated in this solution.