# Question 2. Exchange Rates: theory and empirics From the website of Saint Louis

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Question 2. Exchange Rates: theory and empirics
From the website of Saint Louise Fed, you can find the monthly exchange rate data for the Euro against the USD (https://fred.stlouisfed.org/series/EXUSEU), the US CPI[1] (https://fred.stlouisfed.org/series/CPIAUCSL) and the Eurozone CPI (https://fred.stlouisfed.org/series/EA19CPALTT01IXOBM), for all series, select the data from 1999-01-01 to 2022-12-01.
Compute the monthly changes in the exchange rate between the Euro and USD and compute the monthly changes in the price ratio between the US the EU (i.e., , while the price indexes are approximated by the CPIs). Plot these monthly changes on the same figure.
Which one is more variable, the exchange rate or the price ratio? Explain
Could you offer an explanation for the phenomena you observed above?
How does the figure fit the prediction from the Purchasing Power Parity (PPP) approach to the exchange rate? Explain
The exchange rate is more variable than the price ratio. While the USD inflation rate is considerably quicker than the Euro, as both of the two dashed lines on the above graph fitting the pattern of the data are upward sloping, the relative PPP roughly fulfilled with USD depreciated against the euro in the previous 20+ years.

Plot the exchange rate between the Euro and the USD and the price ratios on the same figure.

[1] For urban consumers only, but the US has very high urbanization rate. So this data can be viewed as nationally representative.

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