(a) Under the monetary approach to the exchange rate theory, money supply growth at a constant rate, eventually results in ongoing price level inflation at the same rate, but changes in this long-run inflation rate do not affect the full-employment output level or the long-run relative prices of goods and services.
b) If non-tradable goods prices rise faster in country A than in country B, and non- tradable goods prices rise faster than prices in general, the currency of country A will appear to depreciate by more than is called for by PPP as measured by price indices. (Assume countries A and B are similar in other respects.)
c) Suppose that on January 1, the yen price of the dollar is 120. Over the year, the Japanese inflation rate is 5 percent and the U.S. inflation rate is 10 percent. If the exchange rate is $1 = Y130 at the end of the year, the yen appear to be overvalued.
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