If the price level recently increased by 20 % in England...

If the price level recently increased by $20 \%$ in England while falling by $5 \%$ in the United States, how much must the exchange rate change if PPP holds? Assume that the current exchange rate is 0.55 pound per dollar.

Key Concepts

Exchange Rate Adjustment

The process by which the nominal exchange rate changes in response to differences in inflation rates. According to PPP, if one country experiences higher inflation than another, its currency should depreciate relative to the other currency, ensuring that purchasing power remains equivalent across countries.

Relative Purchasing Power Parity

A specific form of PPP that relates the percentage changes in the exchange rate to the inflation rate differentials between two countries. It asserts that the rate of depreciation or appreciation of a currency should equal the difference in the inflation rates, reflecting how much more or less expensive domestic goods become compared to foreign goods.

Purchasing Power Parity (PPP)

The theory that in the long run, exchange rates adjust such that identical goods cost the same in different countries when prices are expressed in a common currency. This concept allows for a comparison of price levels and is used to assess whether a currency is overvalued or undervalued relative to another.

Inflation Differential

The difference in the inflation rates between two countries, which can lead to differences in price levels over time. A higher inflation rate in one country compared to another indicates that its goods become relatively more expensive, requiring a corresponding adjustment in the exchange rate to maintain purchasing power parity.

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