As of today, the spot exchange rate is €1.00 = $1.25 and the rates of inflation expected to prevail for the next three years in the U.S. is 2% and 3% in the euro zone. What spot exchange rate should prevail three years from now?

Question

Quizplus · Accepted Answer

To calculate the future exchange rate, we need to calculate the inflation differential between the euro zone and the U.S. for the next three years, and then adjust the spot exchange rate accordingly.
 
For the U.S., the inflation rate is 2% per annum for three years, so the total inflation over the three years will be:
(1 + 0.02)^3 = 1.0612
 
For the euro zone, the inflation rate is 3% per annum for three years, so the total inflation over the three years will be:
(1 + 0.03)^3 = 1.0927
 
The inflation differential is therefore:
1.0927/1.0612 - 1 = 0.0296 or 2.96%
 
The future spot exchange rate will then be:
€1.00/$1.25 × (1 + 0.0296) = €1.00/$1.2139
 
Therefore, the best choice is option B.

As of Today, the Spot Exchange Rate Is €1