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mt2_fall_2007_q2_sol - linearization which the `inflation...

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Question 2 Real FX Rate Base Year U.K. U.S. USD/GBP GBP/USD U.K. goods/U.S. goods Price Ratio 2003 213 84 1.90000 0.52632 1.00000 4.81786 2004 220 90 1.97094 0.50737 1.00000 Inflation 3.2864 7.1429 0.0373 diff 3.8565 Nominal Exchange Rates The economic interpretation is that U.K. inflation was 3.27% ({\em i.e.}, 220/213) whereas U.S. inflation was 7.14\%. PPP implies that the U.S. dollar should depreciate by (roughly) the difference in inflation rates, 3.86\%. The appreciation rate on USD is 1.97/1.9 = 3.68%, which is roughly what the inflation difference dictates (the difference is due to
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Unformatted text preview: linearization which the `inflation difference' implicitly assumes). Answers which are approximate --- as in my above verbal explanation --- should be penalized lightly -- 2 marks only. The question, and the associated problem set from which it derives, asks for exact calculations, but approximate ones that show an understanding of the essence of the PPP idea are almost fine. <== this is the ratio of base year prices, P_b/P^*_b...
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