Suppose purchasing power parity holds.If in 1997 the price level in the United States is 100,the price level in Japan is 10,000,and the nominal exchange rate is 100 yen per dollar,while in 1998 the price level in Japan rises to 10,500 and the nominal exchange rate rises to 105,then the price level in the United States in 1998 must be
A)95.
B)100.
C)105.
D)110.25.

Question

Quizplus · Accepted Answer

Purchasing Power Parity (PPP) suggests that in the long run, exchange rates should adjust to equalize the price of a basket of goods across different countries. Given the initial conditions, the real exchange rate between the US and Japan remains constant if the price levels change in proportion to the change in the nominal exchange rate. From 1997 to 1998, the nominal exchange rate changed from 100 yen per dollar to 105 yen per dollar, a 5% increase. The price level in Japan increased from 10,000 to 10,500, also a 5% increase. For PPP to hold, the price level in the United States must remain constant, as the proportional change in the nominal exchange rate and the foreign price level are the same, leaving the real exchange rate unchanged. Therefore, the price level in the United States in 1998 must remain at 100.

Suppose Purchasing Power Parity Holds