3. Answer the following on real exchange rate.

A. What is purchasing power parity (PPP)? What does PPP theory imply about equilibrium real exchange rate? What does PPP theory predict in terms of the relationship between the nominal exchange rate and inflation differential between countries?

B. Why are price levels generally higher in more developed economies? Why do more rapidly developing economies generally experience higher domestic inflation than those growing more slowly? What do these observations imply about equilibrium real exchange rate?

C. With the slowing of the global economy, especially in China, the demand for key commodities (e.g. oil, iron ore, coal) has declined significantly and so have their price. In this backdrop, the real exchange rate of the Australian dollar has depreciated significantly, mainly on the back of the depreciation of the nominal exchange rate (i.e., weaker AUD). Shouldn't the Australian central bank be worried about this? Doesn't this reflect a massive loss in confidence in Australia?

D. After many years of rapid productivity growth in the tradable sector, your economy loses its "mojo" and begins experience a very sharp productivity slowdown. What does this imply about your equilibrium real exchange rate? Does it need to appreciate, depreciate, or there is no need for any real exchange rate adjustment? If your currency is fixed, how would the real exchange rate adjustment (if needed) take place? How would the adjustment differ if your exchange rate is flexible? Can you think of real-life examples of the two different paths of adjustment?