ECONOMICS QUESTION

4. Throughout the year in 1980, inflation in the US was 13.5% while, in the UK, it was 18%. During that same year, the exchange rate, $/f, moved from 2.225 on January 1st to 2.292 on December 31st. Find this point on Figure 20.1 below (each point corresponds to a specific year between 1975 and 2006). Does this point meet the relative PPP criteria? Why or why not? Figure 20.1: Purchasing Power Parity Test for U.K.-U.S. data. (1975-2006) 0.040 0.020 0.000 -0.300 -0.200 0.100 9.000 0.100 0.200 0.300 -0.020- 40.040 nUS-nUK 0.060 -0.080 0.100 -0.120 -0.140 - 0.160 (Et-Et-1)/Et-1 Sources: adapted from the Bank of England and the Bureau of Labor Statistics. The inflation differential is plotted on the y-axis and the rate of depreciation on the x-axis. Relative PPP holds when these are equal i.e. all the observation points are on the upward sloping dotted line. Out of 31 observations, no more than 3 are close to the line. Use the relative PPP equation to figure out whether these data support the relative PPP hypothesis