In the spot market, $1 is currently equal to £.55. The expected inﬂation rate in the U.K. is 4 percent and in Canada 3 percent. What is the expected exchange rate two years from now if relative
Purchasing power parity exists?

Question

Quizplus · Accepted Answer

Relative Purchasing Power Parity (PPP) suggests that the exchange rate between two countries should adjust to reflect changes in the price levels of the two countries. The formula to calculate the expected exchange rate after two years, based on relative PPP is:

Expected exchange rate = Spot exchange rate * (1 + Home country inflation rate) / (1 + Foreign country inflation rate)

Here, Home country is the U.K. and Foreign country is Canada.

Expected exchange rate = £.55 * (1 + 0.04) / (1 + 0.03) = £.5611

Therefore, the correct answer is D) £.5611.

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