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Q. 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$/ERearrange
R$ - 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.
Q. What are the three main reasons why governments sometimes chose to devalue their currencies? Answer: 1. Permit the government to fight domestic unemployment despite the
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