Ch 8 Problems

3. Suppose that the price level in Canada is CAD16,600, the price level in France is EUR20,750, and the spot exchange rate is EUR1.57/CAD.

a. What is the internal purchasing power of the Canadian dollar? Answer: It is probably best to calculate the purchasing power of CAD10,000. If we divide this amount by the price level in Canada of CAD16,600, we find CAD10,000 =0.6024 consumption bundles CAD16,600 / consumption bundle

b. What is the internal purchasing power of the euro in France? Answer: Performing a similar calculation to the one in part a., we find EUR10,000 = 0.4819 consumption bundles EUR20,750 / consumption bundle

c. What is the implied exchange rate of EUR/CAD that satisfies absolute purchasing power parity? Answer: The implied PPP exchange rate equates the internal purchasing power of the CAD to its external purchasing power. This implies that the PPP exchange rate is the ratio of the French price level in euros to the Canadian price level in Canadian dollars: EUR20,750 EUR1.25 SPPP ( EUR/CAD ) = = CAD16,600 CAD

d. Is the Canadian dollar overvalued or undervalued relative to the euro? Answer: Because the actual exchange rate of EUR1.57/CAD is greater than the PPP exchange rate, the Canadian dollar is overvalued on the foreign exchange market because it would have to weaken considerably to move from EUR1.57/CAD to EUR1.25/CAD.

e. What amount of appreciation or depreciation of the Canadian dollar would be required to return the actual exchange rate to its PPP value? Answer: The exchange rate moves from the actual value of EUR1.57/CAD to the PPP value of EUR1.25/CAD for a percentage change of 1.25/1.57 1 = - 0.2038. This is a 20.38% depreciation of the Canadian dollar.

4. Suppose that the rate of inflation in Japan is 2% in 2009. If the rate of inflation in Germany is 5% during 2009, by how much would the yen strengthen relative to the euro if relative purchasing power parity is satisfied during 2009? Answer: The approximately...