Quiz 8: Purchasing Power Parity and Real Exchange Rates


The consumer index in United States is being provided to determine the inflation in US. Increase in the consumer price index from 350 to 365. Price indexes are nothing but the price level ratios of a given year to the base year price level. Base year remains constant for both the consumer price index under the consideration. In this case, the price indexes ratio has to be determined and subtracting one from the answer will yield the inflation rate. img On substituting the variables in the above equation: img img Thus, the rate of inflation is 4.286%.

Purchasing power of the money is also called as the real value of money. This actually gives an indication about the goods and the services which can be actually purchased with the given money. First price level has to be measured in determining the purchasing power which is nothing but the weighted average price of goods and services which the people are consuming. The weights are nothing but the share of the goods and services in the total bundle of consumption of the individuals. Then the purchasing power is being determined by reciprocating the price level. The price level units are the amount of money per consumption bundle and the purchasing power units are nothing but the consumption bundles per unit of amount (money).

Futures trader observes the purchasing and selling price of wheat in Chicago and makes a note of the forward exchange rate between USD and yen for three months. Details are provided in order to determine the transaction costs. img First the ratio of future price to forward exchange rate has to be determined in order to determine the forward dollar price. img The trader can buy wheat in Chicago for $3.00 per bushel and sells it in Tokyo, if in case the transportation costs is lesser than the difference that is $0.14 (i.e. $3.14 - $3.00) per bushel, then arbitrage profit is possible. Thus a minimum transaction costs is required to create the situation which do not represent the unexploited profit which is $0.14 per bushel.