7. A currency is overvalued (undervalued) if it has appreciated more (less) than the inflation rate differential between two countries as implied by Prices, bxchange Rates, and Purchasing Power Party 151 tely PPP. DE EXERCISES 1. Asume that the cost of a particular basket of goods is equal to $108 in the United States and 14,000 in Japan. a. What should the /$ exchange rate be according to absolute PPP? b. If the actual exchange rate were equal to 120, would the dollar be considered undervalued or overvalued? 2. Suppose that the inflation rate in India is 100% and the inflation rate in the United States is 5%. According to relative PPP, what would hap- pen to the value of dollar/rupee exchange rate? 3. If nontradable goods prices rise faster in country A than in country B, and tradable goods prices remain unchanged, determine whether cur- rency A will appear to be overvalued or undervalued. 4. Explain why relative PPP may hold when absolute PPP does not? 5. List four reasons why deviations from PPP might occur; then carefully explain how each causes such deviations? 6. What is the real exchange rate"? What does the real exchange rate equal if absolute PPP holds? FURTHER READING Lothian, J.R., Taylor, M.P., 1996. Real exchange rate behavior: the recent float from the perspective of the past two centuries. J. Polit. Econ. 104 (3), 488-509. Officer, L.H., 1982. Purchasing Power Parity and Exchange Rates: Theory. Evidence, and Relevance. JAI Press, Greenwich. Ravn, M.O., Schmitt-Grohe, S., Uribe, M., 2007. Pricing to habits and the law of one price. Am. Econ. Rev. 97 (2), 232-238. May. Taylor, A.M., Taylor, M.P, 2004. The purchasing power parity debate. J. Econ. Perspect. 18 135-158. pmist online, 2016. The Big Mac Index, Patty Purchasing Parity. July 23