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a) The normal value of any two currencies in terms of each other is determined by the rates between the average prices in the two countries of those commodities that enter into international trade. Under purchasing power parity (PPP) currencies are valued for what they would buy. However this is only valid under a free trade regime and in respect of goods and services that enters into international trade. In practice, differences in prices arise from transport costs tariffs and other types of taxation.
b) A change in the exchange rate may come about independently of the internal price level. For example, an increase in national income may decreases the value of imports relative to exports and the exchange rate of the local currency may fall.
c) The present value of paper currency is governed to some extend by estimates of its future value. If the future value is expected to be high its present value will rise.
d) The relative price level governs only the equilibrium rate of exchange. At any given time the actual market rate may diverge from the equilibrium rate according to the terms of balance of payment at the time. The purchasing power parity explains the ultimate long run rather than the immediate forces determining the rate of exchange.
e) The purchasing power parity assumes that the changes in the price of goods that enter into international trade are followed by similar changes in the prices of all other goods. But it is known that the forces that determine the price of one good may differ to those that determine the price of another. The foreign exchange market is dominated by speculative influences which tend to deflect the market rate of exchange from the normal or equilibrium rate.
Wilfykil answered the question on March 9, 2019 at 08:14
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