Given the following information, answer this and the following 2 questions. You

Question

Given the following information, answer this and the following 2 questions. You have just rented a villa in Paris for a vacation of 12 months later. Your French landlord wants to preserve real income in euros, so the present monthly rent of €2,000/month will be adjusted upward or downward for any change in the French cost of living between now and then. You expect French inflation to be 3% and US inflation to be 8% over the coming year. You believe implicitly in the theory of purchasing power parity, and you note from the Financial Times that the current spot rate is € 0.8/$.

a. According to Purchasing Power Parity, what should be the spot-rate 1 year later?

b. What should be the total monthly rent in euros a year from now?

c. How many US dollars will you need one year from now to pay your first month’s rent?

Explanation / Answer

a. spot rate in a year = 0.8*1.03/1.08 = 0.7630

b. total rent in Euros in one year = 2000*1.03 = 2,060

c. US dollars = 2060/0.7630 = 2699.87

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