Assume an equilibrium state in which European inflation and U.S. inflation are both 4 percent. If U.S. inflation suddenly decreases to 2 percent, the euro will ____ against the dollar by approximately ____ percent, according to purchasing power parity.
A) appreciate; 2
B) depreciate; 2
C) appreciate; 4
D) depreciate; 4
E) none of the above

Question

Quizplus · Accepted Answer

According to purchasing power parity, a decrease in inflation should lead to appreciation of the currency. Therefore, if U.S. inflation decreases, the dollar should appreciate. However, we are looking for the effect on the euro. A decrease in the value of the dollar should cause the euro to appreciate against the dollar. The percentage change in the exchange rate will be approximately equal to the difference in inflation rates between the two countries. Therefore, the euro should appreciate by approximately 2 percent.

Assume an Equilibrium State in Which European Inflation and U