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Describe and explain the relationship between expected inflation rates in two countries and their interest rate differential according to the PPP theory.
Answer: Expected price rises is given by the following equation:
_e= (Pe - P)/P where Pe is the expected price level in a country a year from today.
If relative PPP is expected to embrace then:
(Ee$/E - E$E)/E $/E = _US,t - _E,t.
Join the expected version of relative PPP with the interest parity condition R$ = RE+ (Ee$/E - E$/E)/E$/E
Rearrange
R$ - RE = _US,t - _E,t
If since PPP predicts currency depreciation is expected to offset international inflation differences the interest rate difference should equal the expected inflation difference.
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