At the beginning of 2002 the AUD/USD exchange rate was 1.9585 and the 2002 inflation rates were 3.10% for Australia and 2.33% for the US.
What should the AUD/USD exchange rate have been at the end of 2002, according to PPP theory?
A) USD/AUD 0.5068
B) AUD/USD 1.9439
C) AUD/USD 1.9732
D) none of the given answers

Question

At the beginning of 2002 the AUD/USD exchange rate was 1.9585 and the 2002 inflation rates were 3.10% for Australia and 2.33% for the US.
 What should the AUD/USD exchange rate have been at the end of 2002, according to PPP theory?
A) USD/AUD 0.5068
B) AUD/USD 1.9439
C) AUD/USD 1.9732
D) none of the given answers

Quizplus · Accepted Answer

The correct answer is C because according to the PPP theory, the exchange rate should adjust to equalize the price of a basket of goods in both countries. The inflation rate differential between the two countries is 3.10% - 2.33% = 0.77%. Therefore, the AUD should appreciate against the USD by 0.77% over the year. The new exchange rate should be 1.9585 * (1 + 0.0077) = 1.9732.

At the Beginning of 2002 the AUD/USD Exchange Rate Was