Question

If the price level recently increased by$19\%$in England while falling by $6\%$in the Canada, by how much must the exchange rate change if PPP holds? Assume that the current exchange rate is $0.58$pound per dollar.

Short answer

$Theexchangerateis0.6875andAggregateinflationis25\%.$

Step-by-step solution

Concept Introduction

Inflation is that the overall increase normally index of an economy. Inflation causes increase within the price of products and services which decreases exports and fall in aggregate demand.

Exchange rate is that the rate at which domestic currency is exchanged with foreign currency. rate provides the relative price of excellent in terms of domestic and foreign currency. rate of exchange is incredibly volatile and it affects the economy's foreign trade. rate is calculated as:

$\text{Exchange Rate}\left(e^t\right)=\frac{\text{Foreign pricelevel}\left({\mathrm{P}}_t\right)}{\text{DomesticPricelevel}\left({\mathrm{P}}_{\mathrm{d}}\right)}$

: 

Exchange rate is$0.58.$

Inflation in England is$19\%.$

Deflation in US is$6\%.$

Calculation of exchange rate:

$\text{Exchange Rate}\left(e^t\right)=\frac{\text{Foreign pricelevel}\left({\mathrm{P}}_t\right)}{\text{DomesticPricelevel}\left({\mathrm{P}}_{\mathrm{d}}\right)}$

Substitute, the value of exchange rate and aggregate inflation:

Exchange rate$=0.55\times 125\%$

$=0.55\times \frac{125}{100}=0.6875$

Exchange rate would change from $0.55to0.6875$pound per dollar. Increase in index number in England ends up in inflation in British economy and depreciation within the rate of exchange. In US fall in indicator creates deflation and deflation ends up in increase in rate of exchange. thanks to inflation in England and deflation in US rate increase by $25\%.$

Calculation

$$\begin{gathered} Calculationofaggregateinflation: \\ Aggregateinflation=InflationinEngland+DeflationinUS \end{gathered}$$

$$\begin{gathered} =19\%+6\% \\ =25\% \end{gathered}$$