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Unformatted text preview: mestic country P* is the price of same product in a foreign country E= domestic currency price of the foreign currency. If P and P* can be interpreted as the domestic and foreign price index, representing the respective inflation figures , the exchange rates becomes the ratio of relative price levels in the two countries.
An important application of the PPP theory is that the nominal exchange rate must adjust significantly and sufficiently so as to reflect /compensate the underlying inflation difference. Once this happens, the international competitiveness of any country’s product I the world market shall be maintained. As per PPP theory
The real Exchange rate= Nominal exchange rate * Foreign price index/ domestic price index.
= 44 *100/110= 40
where 44= exchange rate
100= foreign price index and 110= domestic price index which has increased to 110 due to inflation.
The real exchange rate appreciates to 40. This adversely...
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- Fall '13