2. External and Internal Purchasing Power:

At the start of the year, price level is 10,000 USD per consumption

basket in USA and 8,000 Euros in Europe. The exchange rate at the

start of the year is 1.40 USD/EUR. The infation rate in USA over the

year is 2% and in Europe is 6%. The exchange rate observed at the

end of the year is 1.30 USD/EUR.

a) Compute internal purchasing power (IPP) and External Purchasing

Power (EPP) of both the currencies: USD and EUR at start and end of the year

b) What exchnage rate should prevail at start of the year between USD/EUR

according to Absolute PPP theory, so that IPP and EPP are equalized?

Do the similar computations for end of the year. (You will have to compute

price levels at end of the year given inflation rates)

c) Compute real exchange rate between USD/EUR at the start and end of

the year. How can one use Real exchnage rate to determine if the currency

is undervalued or overvalued?

d) Which currency is overvalued in the market? or are they fairly priced? (Try to use Aboslute PPP)

e) What exchange rate should have been observed at end of the year according

to Relative PPP? (Try to eqaute inflation rates and changes in exchange rates).

f) Is end of the year exchange rate in line with Relative PPP theory? How can you

use real exchnage rate to determine if relative PPP holds or not?

Please show/explain all steps in answering the questions. Thanks!