Log out Go to App
Go to App

Learning Materials

Features

Discover

Chapter 30: Problem 8

According to the theory of purchasing power parity, if the inflation rate in Australia is higher than the inflation rate in New Zealand, what should happen to the exchange rate between the Australian dollar and the New Zealand dollar? Briefly explain.

Short Answer

Expert verified
In terms of the Purchasing Power Parity theory, due to a higher inflation rate in Australia compared to New Zealand, the Australian dollar should depreciate against the New Zealand dollar. This is to maintain the same purchasing power for the same basket of goods in both countries.

Step by step solution

01

Understanding Purchasing Power Parity (PPP)

The theory of Purchasing Power Parity (PPP) stipulates that for two countries, the exchange rate should adjust so that a basket of goods costs the same amount in either country. If one country's inflation rate is higher, it means the currency is depreciating since more of the currency is needed to purchase the same goods.
02

Identify the country with higher inflation

According to the exercise, Australia has a higher inflation rate than New Zealand.
03

Analyze the impact on the exchange rate

When a country experiences higher inflation, the value of its currency decreases relative to other currencies. In this case, assuming that New Zealand's inflation remains unchanged, the Australian dollar should depreciate against the New Zealand dollar in order to maintain PPP.
04

Summing it up

In light of the PPP theory, a higher inflation rate in Australia as opposed to New Zealand would cause the value of the Australian dollar to decrease relative to the New Zealand dollar so that the same basket of goods cost the same in both countries. The depreciation of the Australian dollar would help restore parity in terms of purchasing power by making goods in Australia less expensive when bought with New Zealand dollars.

Unlock Step-by-Step Solutions & Ace Your Exams!

  • Full Textbook Solutions

    Get detailed explanations and key concepts

  • Unlimited Al creation

    Al flashcards, explanations, exams and more...

  • Ads-free access

    To over 500 millions flashcards

  • Money-back guarantee

    We refund you if you fail your exam.

Start your free trial

Over 30 million students worldwide already upgrade their learning with Vaia!

One App. One Place for Learning.

All the tools & learning materials you need for study success - in one app.

Get started for free

Most popular questions from this chapter

Which European countries currently use the euro as their currency? Why did these countries agree to replace their previous currencies with the euro?

(Related to the Don't Let This Happen to You on page 1061 ) Briefly explain whether you agree with the following statement: "The Federal Reserve is limited in its ability to issue paper currency by the amount of gold the federal government has in Fort Knox. To issue more paper currency, the government first has to buy more gold."

An article in the Toronto Star discussed the Canadian teams that play in the National Hockey League, the National Basketball Association, Major League Baseball, and Major League Soccer. The article noted, "Under their collective agreements players get paid in U.S. dollars. The majority of [team] revenue, however, is in Canadian currency." Are Canadian professional sports teams better off when the Canadian dollar increases in value relative to the U.S. dollar or when it decreases in value? Briefly explain.

Briefly describe the four determinants of exchange rates in the long run.

What were the main factors behind the globalization of capital markets in the 1980 s and 1990 s?
See all solutions

What do you think about this solution?

We value your feedback to improve our textbook solutions.

Study anywhere. Anytime. Across all devices.

Sign-up for free