Assume the current spot rate between the UK and the U.S.is £.6402 per $1.The expected inflation rate in the U.S.is 2.8 percent.The expected inflation rate in the UK is 2.4 percent.If relative purchasing power parity exists, what will the exchange rate be two years from now?

Question

Quizplus · Accepted Answer

Relative purchasing power parity implies that the exchange rate should adjust to reflect the difference in inflation rates between two countries. In this case, the U.S. is expected to have higher inflation, which should lead to a depreciation of the dollar relative to the pound.

Using the formula:

Expected exchange rate = Current spot rate × (1 + domestic inflation) ÷ (1 + foreign inflation)

Expected exchange rate two years from now = £.6402 × (1 + 2.8%) ÷ (1 + 2.4%)

Expected exchange rate two years from now = £.6351/$1

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