1. Consider two countries, France and Russia, and two goods, wine and vodka. Assumethat in both countries, both wine and vodka account for equal shares in their respectiveconsumption baskets. Suppose that the dollar-price of wine in France is half of thedollar-price of wine in Russia. In order for absolute PPP to hold, what must be theratio of the dollar-price of vodka in France relative to the dollar-price of vodka inRussia?2. Suppose the inflation rate in Australia is expected to be 0.02 and its currency isexpected to appreciate against that of South Africa by 0.04. In order for relativePPP to hold, what must be the expected inflation rate in South Africa (state youranswer to two decimal places)?3. Suppose the price for one ounce of gol

France and Russia

Purchasing Power Parity (PPP):

a) Ratio of the dollar-price of vodka in France relative to the dollar-price of vodka in Russia = 2:1

b) For relative PPP to hold, the expected inflation rate in South Africa must be 0.06

Explanation:

a) Data and Calculations:

Wine in France = Vodka in Russia

Dollar price of wine in France = 1

Dollar price of wine in Russia = 2

Ratio of the dollar-price of vodka in France relative to the dollar-price of vodka in Russia = 2:1

b) This means that if the price of vodka in Russia is $1 per bottle, for instance, the price of vodka in France will be equal to $2 per bottle.

c) Data and Calculations:

Expected inflation rate in Australia = 0.02

Expected currency appreciation of Australian dollar against that of South Africa = 0.04

For relative PPP to hold, the expected inflation rate in South Africa must be 0.06 (0.02 + 0.04).

d) France and Russia's absolute purchasing power parity will hold when the purchasing power of Francs is exactly equal in France's domestic economy and in the Russian economy, once it is converted into the Russian ruble at the market exchange rate.  For our example, the relative purchasing power parity (RPPP) states that exchange rates and inflation rates (price levels) in Australia and South Africa should equal out over time.

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