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Suppose the dollar price of a reference commodity basket sold in the US is $45, while the euro price for the same basket is €30 in the EA.
a. Write down the absolute and relative purchasing power parity (PPP) formula and find the dollar/euro exchange rate predicted by the absolute PPP theory. Use this example to explain the rationale behind the law of one price theory and the absolute PPP theory.Suppose the EA inflation rate is 3% over one year while the inflation rate in the US is lower and equal to 2% over one year.

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