If a U.S. dollar currently purchases 1.3 Canadian dollars and the inflation rate in Canada over the next year is 5 percent while it is 2 percent in the U.S., we should expect a U.S. dollar to purchase:

Question

Quizplus · Accepted Answer

The purchasing power parity (PPP) theory states that the exchange rate between two currencies should be equal to the ratio of the price levels in the two countries. If the inflation rate is higher in one country than another, its currency should depreciate relative to the other currency to maintain parity. Therefore, if Canada's inflation rate is 5%, the Canadian dollar should depreciate by that much so that 1 USD can buy more CAD.

The new exchange rate would be:
1.3 x 1.05 / 1.02 = 1.339

Therefore, a US dollar should purchase 1.339 Canadian dollars after a year.

If a US Dollar Currently Purchases 1