The U.S. inflation rate is expected to be 4 percent over the next year, while the European inflation rate is expected to be 3 percent. The current spot rate of the euro is $1.03. Using purchasing power parity, the expected spot rate at the end of one year is $____.
A)1.02
B)1.03
C)1.04
D)none of the above

Question

Quizplus · Accepted Answer

According to the purchasing power parity theory, the exchange rate between two currencies should equalize the price of a basket of goods and services in each country. Therefore, the expected exchange rate at the end of one year can be calculated as:

Expected exchange rate = Current exchange rate x (1 + Domestic inflation rate) / (1 + Foreign inflation rate)
Expected exchange rate = 1.03 x (1 + 0.04) / (1 + 0.03) = 1.04

Therefore, the expected spot rate at the end of one year is $1.04.

The US Inflation Rate Is Expected to Be 4 Percent Over