Problem set 1 1. PPP-adjusted exchange rates and cross country comparisons In class, we briefly discussed how a country'

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Problem Set 1 1 Ppp Adjusted Exchange Rates And Cross Country Comparisons In Class We Briefly Discussed How A Country 1 (37.08 KiB) Viewed 56 times

Problem set 1 1. PPP-adjusted exchange rates and cross country comparisons In class, we briefly discussed how a country's perceived income relative to the United States would depend on how closely consumption in the country matched the 'representative bundle' used to calculate the PPP exchange rate. In this question, you are going to solve an exercise that helps you understand the concept of purchasing power party (PPP) comparisons better. Set-up: • Consider 2 countries: US and IT and a basket of commodities only comprising of food (F) and clothing (C). • Assume that the set of prices for the commodities in the countries in consideration are: Pus" = 20, Pus=30, PT-100, P = 400 • Additionally, assume that the utility function of a representative consumer in the US is given by: Uus (Eus.Cus) = F5C5 while the utility function of a representative consumer from IT is: UIT (FIT.CIT) = F.6C.4. • Per-capita income in US is 2,000 units of US' currency, while in IT, it's 20,000 units of IT's currency. Questions: (a) Using utility maximization, determine which bundle a consumer from the US vs a consumer from IT will consume. Who is better off? (b) Suppose the OECD decides that the representative bundle is 30 articles of clothing and 50 units of food. Which country's chosen bundle seems 'closer'? (c) What is the PPP exchange rate for IT relative to US? Using this exchange rate, calculate percapita income for IT in PPP-adjusted units, i.e.. Who has the larger per-capita income? By how much? (d) Now suppose the OECD had chosen a basket with 120 units of food and 20 units of clothing. Calculate the PPP exchange rate and use it to calculate per-capita income in IT. How have the results changed? Why?