Assume the current spot rate between the UK and the U.S.is £0.6391 per $1, the expected inflation rate in the U.S.is 1.9 percent, and the expected inflation rate in the UK is 2.1 percent.If relative purchasing power parity exists, what will the exchange rate be next year?

Question

Quizplus · Accepted Answer

According to relative purchasing power parity, the exchange rate should adjust to reflect the difference in expected inflation rates. The expected appreciation of the pound is 2.1% (inflation difference between the UK and the US) minus 1.9% (expected US inflation), which equals 0.2%. Therefore, the new exchange rate should be (£0.6391 × (1 + 0.002))/$1 = £0.6404/$1.

Assume the Current Spot Rate Between the UK and the U.S.is