Problem 1. Relative Purchasing Power Parity. Suppose that Turkish inflation is expected to reach 18% this year. At the s

[answerhappygod]

Problem 1. Relative Purchasing Power
Parity.
Suppose that Turkish inflation is expected to reach 18% this
year. At the same time, the U.S. inflation
rate could be at 5%.
a) Explain the difference between absolute and relative PPP?
What are the main issues one encounters
when testing the absolute PPP?
b) Using the concept of Relative Purchasing Power Parity, how do
you expect the exchange rate to
react? Does this mean that the lira is likely to appreciate
relative to the dollar? Explain briefly the
economic intuition behind the expected reaction of exchange
rates to difference in inflation rates.
c) For what types of goods does the law of one price hold quite
well? Why?
d) What are the implications of assuming that both Relative PPP
(with expected inflation in both
countries) and Uncovered Interest Rate Parity (without risk
premium) hold? What happens if you
introduce a risk premium?