If, in time period #1, the equilibrium value of the pound is $1.60, but then U.K. prices double between time period #1 and time period #2 while U.S. prices rise by 60 percent, then the (relative) purchasing power parity theory would say that the equilibrium value of the pound in time period #2 is

Question

Quizplus · Accepted Answer

According to the relative purchasing power parity theory, the exchange rate should adjust to offset differences in inflation rates between two countries. In this case, the inflation rate in the UK was much higher than that in the US (100% compared to 60%). Therefore, the pound should depreciate by the ratio of the inflation rate differential, in this case, 1.67 (100/60). So, the new equilibrium exchange rate would be 1.60/1.67 = 0.96. However, we are looking for the value of the pound, not the dollar, so we need to take the inverse of this value, which is approximately $1.28. Therefore, the correct answer is C.

If, in Time Period #1, the Equilibrium Value of the Pound