Relative Purchasing Power Parity (PPP)

Relative Purchasing Power Parity (PPP) is an economic theory that suggests that in the long run, exchange rates between two countries should adjust to reflect differences in the inflation rates of the two countries. According to PPP, if a country experiences higher inflation compared to another country, its currency should depreciate relative to the other country's currency in order to maintain price competitiveness.

a. Impact of Inflation Differential on Exchange Rate

When there is a significant difference in inflation rates between two countries, the exchange rate between their respective currencies is expected to adjust to reflect the inflation differential. In this case, Ethiopia's inflation rate is 100 percent, while the US inflation rate is 5 percent.

According to relative PPP, the Ethiopian birr exchange rate against the US dollar should depreciate because Ethiopia's inflation rate is significantly higher than that of the US. The depreciation of the Ethiopian birr would make Ethiopian goods relatively cheaper compared to US goods, helping to maintain price competitiveness.

In simple terms, a higher inflation rate in Ethiopia erodes the purchasing power of the birr, making it less valuable compared to the US dollar. As a result, more birr would be required to purchase the same amount of US goods or currency.

b. Impact of Tripled Price Level on Exchange Rate

If the Ethiopian price level were to triple, it means that the overall price level in Ethiopia has increased threefold. This would indicate a significant increase in inflation.

To determine the impact on the Ethiopian birr exchange rate against the US dollar, we can use the concept of relative PPP. Relative PPP suggests that the exchange rate between two currencies should adjust to reflect differences in the price levels of the two countries.

If the Ethiopian price level triples, it means that the Ethiopian inflation rate is significantly higher than that of the US. According to relative PPP, the Ethiopian birr would need to depreciate in order to maintain price competitiveness.

Assuming the US price level remains relatively stable, the exchange rate would adjust in such a way that it would take more Ethiopian birr to purchase the same amount of US goods or currency. Therefore, the Ethiopian birr exchange rate against the US dollar would depreciate.

In conclusion, according to relative PPP, in a situation where Ethiopia experiences significantly higher inflation compared to the US, the Ethiopian birr would be expected to depreciate against the US dollar. Additionally, if the Ethiopian price level were to triple, the Ethiopian birr exchange rate against the US dollar would also depreciate.