Suppose the GDP deflator in the United States is 125 and the GDP deflator in Japan is 100.Also assume the United States has trade barriers on Japanese goods in the form of quotas.What does this imply about the exchange rate of yen per dollar under the theory of purchasing power parity in the long run?

Question

Quizplus · Accepted Answer

According to the theory of purchasing power parity, the exchange rate between two countries should adjust such that the purchasing power of a currency in one country equals the purchasing power of the same currency in another country. In this case, since the GDP deflator in Japan is lower than the United States, it implies that prices in Japan are lower than prices in the United States. Therefore, the yen should be able to buy more goods in Japan than in the United States. The trade barriers on Japanese goods will make Japanese goods more expensive in the United States, which will further increase the relative price of goods in the United States. This will cause the yen to depreciate against the dollar, such that the exchange rate of yen per dollar will be less than 0.8. Therefore, the correct answer is D.

Suppose the GDP Deflator in the United States Is 125