In the spot market, $1 is currently equal to £.5086. The expected inﬂation rate in the U.K. is 3 percent and in the U.S. 4 percent. What is the expected exchange rate three years from now if
Relative purchasing power parity exists?

Question

Quizplus · Accepted Answer

According to relative purchasing power parity (PPP), the exchange rate should change by the difference in inflation rates between the two countries.

In the U.K., prices are expected to increase by 3% each year, which means that goods that cost £1 today will cost £1.03 in one year, and £1.0927 in three years (1.03^3).

In the U.S., prices are expected to increase by 4% each year, which means that goods that cost $1 today will cost $1.04 in one year, and $1.1259 in three years (1.04^3).

The ratio of the two exchange rates should equal the ratio of the two price levels (inflation-adjusted exchange rate), so:

Exchange rate in three years = (£1.0927 / $1.1259) = £.9716 per $1

Using the current spot rate of $1 = £.5086, we get:

Exchange rate in three years = ($1 / £.5086) x £.9716 = £1.9160

Rounding to four decimal places, we get:

Exchange rate in three years = £.4935

Therefore, the answer is B, £.4935.

In the Spot Market, $1 Is Currently Equal to £