Purchasing Power Parity

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1.What is the relationship between the exchange rates and relative inflation levels of the two countries? How will this relationship affect Blades’ Thai revenue and costs given that the baht is freely floating? What is the net effect of this relationship on Blades? ANSWER: The relationship between exchange rates and relative inflation rates can be explained by the purchasing power parity (PPP) theory. When one country’s inflation rate is high as compared to another country, then the demand for country’s currency with high inflation rate declines. Due to high inflation rates, the goods of the country become more expensive and demand of the goods falls and a result exports decreases substantially. Also, the imports of the country increases as consumers prefer same products at lower price. Ultimately this leads to depreciation of local currency and appreciation of foreign currency because the demand of foreign currency increase due to increase in imports and demand of local currency will reduce due to fewer exports. Thus, the absolute form of PPP states that prices of similar products of two different countries should be equal when measured in a common currency. The relative form of PPP states that prices of similar products of different countries will not necessarily be the same when measured in a common currency because of market imperfections. So, we can conclude that when the inflation rate of one country increase, the exchange rates fluctuates in such a manner that country with high inflation rate’s currency depreciates and foreign currency appreciates. As per new foreign exchange policy, the baht has become a freely floating currency in the Baht market. As the inflation rate of Thailand is high, this will depreciate Baht currency in Thailand. Blades exports its products to Thailand and Blades’ exports are denominated in baht, a depreciation of the baht will result in a conversion of baht into fewer dollars. So, Blades’ revenue generated in Thailand will be...
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