Question: QUESTION THREE (a) Consider a world that only comprises 2 goods (Good 1, Good 2) and 2 countries (UK and US). Assume that consumption weights

QUESTION THREE (a) Consider a world that only comprises 2 goods (Good 1, Good 2) and 2 countries (UK and US). Assume that consumption weights of these goods for both countries be (0.25, 0.75). The price of the goods at time t are listed below: UK (GBP) US (USD) Good I 20 25 Good 2 20 45 Note: GBP stands for British pound and USD stands for United States dollar. Let the spot exchange rate at time / be equal to 0.50 GBP/USD. Does absolute purchasing power parity (PPP) hold between the UK and the US? (5 Marks) (b) The price of the goods at time t+ / are listed below: UK (GBP) US (USD) Good I 22 25 Good 2 30 45 Using the information in (a), what spot exchange rate at time f+/ does relative purchasing power parity (PPP) imply? (5 Marks) (c) Briefly discuss the role of PPP in the models for exchange rate determinations. Do the PPP relationships hold in the real world? (5 Marks) [TOTAL: 15 MARKS]

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