5. You have just rented a castle in Bavaria for a vacation twelve months hence.

Question

5. You have just rented a castle in Bavaria for a vacation twelve months hence. Your landlord wants to preserve his real income in Euro and so is charging you a monthly rent of 100,000 Euro, to be adjusted upward or downward for any change in the German cost of living between now and then. You expect U.S., inflation to be 10% and German inflation to be 4% over the coming year. You believe implicitly in the theory of purchasing power parity, and you note from The Wall Street Journal that the current spot rate is $.95/. How many dollars do you think you will need one year hence to pay your first month's rent?

Explanation / Answer

Given

Spot Rate 1 Euro = 0.95 USD

Inflation in US = 10%

Inflaytion in Germany = 4%

Fwd Rate acc to PPP theory = Spot Rate * [ 1 + inflation rate in home country ] / [ 1 + inflation rate in foreign country ]

= 0.95 * [ 1 + 0.10 ] / [ 1+0.04 ]

= 0.95 * 1.10 / 1.04

= 0.8304

1 Euro = 0.8304

Monthly Rent = 100,000 Euro * Exchange rate

= 100,000 * 0.8304

= 83,040 USD

Pls comment, if any further assistance is required.

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