Question

Assume $1 is currently equal to £.7741 in the spot market. Assume the expected inflation rate in the U.S. is 2.6 percent while it is 2.3 percent in the U.K. What is the expected exchange rate one year from now if relative purchasing power parity exists?

Answer 1

Answer:

The expected rate is 0.771837.

Explanation:

If relativo purchasing power exists, then the value of the rate in one year is the cost of carrying the asset for that period of time. In the case of currencies, that rate is calculated

$Spot * \frac{1+UK.inflation}{1+US.inflation}$

where the spot is how much £ do you need to purchase one dollar. It is equal to 0.7741. So, the expected exchange rate is

$0.7741 * \frac{1.023}{1.026} = 0.771837$