The current spot rate between Australia and the US is US$0.6789 per AUD$1.The expected inflation rate in the US is 2.1 per cent.The expected inflation rate in Australia is 2.6 per cent.If relative purchasing power parity exists,what will the exchange rate be next year?

Question

Quizplus · Accepted Answer

Relative purchasing power parity suggests that the exchange rate between two currencies should adjust to equalize the price of identical baskets of goods and services. Therefore, the expected exchange rate can be calculated as follows:

Expected exchange rate = Spot rate x (1 + inflation rate of home country) / (1 + inflation rate of foreign country)

Expected exchange rate = 0.6789 x (1 + 0.026) / (1 + 0.021)
Expected exchange rate = 0.6789 x 1.026 / 1.021
Expected exchange rate = 0.6831

Therefore, the expected exchange rate for next year is AUD$1 = US$0.6831.

Option B (AUD$1 = US$0.6755) is the closest answer to the expected exchange rate calculated above.

The Current Spot Rate Between Australia and the US Is