Suppose the expected inflation in the U.S.on January 1,1988 was projected at 5% annually for the next 5 years and at 12% annually in Italy for the same time period,and the lira/$ spot rate that day was currently at L2400 = $1,then the PPP estimate of the spot rate five years from now was
A)1738
B)3314
C)2560
D)2250

Question

Quizplus · Accepted Answer

According to the PPP (Purchasing Power Parity) theory, the exchange rate between two countries should equal the ratio of the countries' price levels. In other words, the exchange rate should adjust for the inflation differential between the two countries.

Using this theory, we can estimate the future spot rate between the US and Italy as follows:

- First, we need to calculate the expected inflation differential between the two countries over the next 5 years:

US inflation rate = 5% annually for 5 years = 27.63% (using the formula: (1+5%)^5 - 1)
Italy inflation rate = 12% annually for 5 years = 79.58% (using the formula: (1+12%)^5 - 1)

- Next, we need to calculate the PPP-adjusted exchange rate between the US and Italy as of January 1, 1993 (5 years from now):

PPP-adjusted exchange rate = Spot rate * (1 + Italy inflation rate) / (1 + US inflation rate)
= 2400 * (1 + 79.58%) / (1 + 27.63%)
= 3313.86

Rounding to the nearest whole number gives us the answer of 3314, which is Choice B.

Suppose the Expected Inflation in the U