Required:

a. Indicate whether the following statement is True of False. (4 marks)

i) The real exchange rate is equal to 1, if the absolute purchasing power parity is not satisfied.

ii) The real exchange rate is not necessarily constant over time, if the relative purchasing power parity does hold.

iii) The deviation from absolute purchasing power parity is not constant in percentage, if the relative purchasing power parity is not violated.

iv) The real exchange rate will not fluctuate from time to time, if the deviation from absolute purchasing power parity is constant over time.

b. Suppose that the Australia price level is initially AUD15,000 per Australian consumption bundle, and the price level in Britain is initially 11,000 per British consumption bundle. With the nominal spot exchange rate equal to AUD1.56/, what is the current real exchange rate? (1 mark)

c. Suppose that over the next year, there is 3% inflation in Australia, there is 1% inflation in Britain, and the nominal exchange rate changes so that relative purchasing power parity is satisfied. What is the expected nominal exchange rate after 1 year? (1 mark)

d. Suppose that the pound actually depreciates in nominal terms by 1% relative to the AUD during the year (ex post).

i) What turns out to be the actual nominal exchange rate after 1 year? (1 mark)

ii) What is the ex post rate of change in real exchange rate? (2 marks)

iii) Has the pound appreciated or depreciated in real terms? (1 mark)

iv) What is the new real exchange rate after 1 year? (2 marks)

v) Based on the real exchange rate observed over the year, is the relative purchasing power parity found to be satisfied or not and what is the reason for your answer? (2 marks)