In the spot market, $1 is currently equal to £.5725. The expected inﬂation rate in the U.K. is 4 percent and in Canada 2 percent. What is the expected exchange rate one year from now if relative
Purchasing power parity exists?

Question

Quizplus · Accepted Answer

Relative purchasing power parity suggests that the exchange rate should change by the difference in inflation rates. Thus, the expected exchange rate is:

Expected exchange rate = Spot rate x (1 + domestic inflation) / (1 + foreign inflation)
Expected exchange rate = .5725 x (1 + .04) / (1 + .02)
Expected exchange rate = .5725 x 1.04 / 1.02
Expected exchange rate = .58395

Therefore, the best choice is C.

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