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RATES
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- this expresses the relationsip between relative inflation and exchange rates
- observe that if > , then should be positive, which implies that the foreign currency will
appreciate
- this theory is more applicable when two countries engage in extensive international trade
with each other; if there is not much trade, then inflation differential will have little effect and
so exchange rate should not be expected to change
SIMPLIFIED PPP RELATIONSHIP
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- less precise
- percentage change in exchange rate should be approximately equal to the difference in
inflation rates between two countries
- appropriately only when inflation differential is small or when the value of is close to zero
SUMMARY of PPP
S1: Local currency should
Relatively HIGH Local Inflation Imports will , exports will depreciate by same degree as
inflation differential
S2: Local currency should
Relatively LOW Local Inflation Imports will , exports will appreciate by same degree as
inflation differential
S3: Local currencys value is not
Local and Foreign Inflation rate No impact of inflation on Import affected by inflation
are SIMILAR or Export volume