Question

If purchasing power parity holds, then if the price of a basket of goods in the U.S. rose from $1.000 to $1,200 and the price of the same basket in Poland rose from 6,400 Polish zloty to 8,000 zloty, then a. the nominal exchange rate would be unchanged and the real exchange rate would appreciate. b. the U.S. dollar would appreciate and the real exchange rate would stay the same. c. the nominal exchange rate would be unchanged and the real exchange rate would depreciate. d. the U.S. dollar would depreciate and the real exchange rate would be unchanged.

Answer 1

Answer:

b) The US dollar would appreciate and the real exchange rate would stay the same.

Explanation:

Increase in Inflation in US: 1,200 / 1,000 - 1 * 100 = 20%

Increase in Inflation in Poland: 8,000 / 6,400 - 1 * 100 = 25%

Law of one price states that identical goods should be exchanged at equal prices in different countries valued in local currencies. This law is known as purchasing power parity theory.

According to the theory, increase (decrease) in prices of goods or a basket of goods in one country will result in depreciation (appreciation) of its currency so exchange rate-adjusted prices are constant across countries.

In our question, the price of basked of goods has increased by 25% in Poland as compared to 20% in U.S. thus implying depreciation of Polish zloty against US dollar or appreciation of US against Policy zloty.