According to the law of one price, after adjusting for exchange rates, identical

Question

According to the law of one price, after adjusting for exchange rates, identical products should sell for same price in all countries. cies will be This relationship states that the percentage change in the future spot exchange rates between two curren equal to the difference in the inflation rates between two countries. This form of law of one price is called: O Absolute purchasing power parity O Relative purchasing power parity Suppose you need to forecast the one-year forward rate between the euro and the U.S. dollar. Based on your research, you expect inflation in the eurozone to be 2.6% next year, whereas inflation in the United States is expected to remain at 1.3% in the coming year. The current spot rate between the two regions can be represented as $1 € 0.8008. Based on the information you have, your estimate of the one-year future spot rate-if you consider the United States as your home country-is Therefore, the higher inflation rate in the eurozone can be expected to lead to a decline in the future spot value of the euro relative to the dollar by The relative purchasing power parity relationship is stronger for countries with: 0 Low inflation rates O High inflation rates Flash Player WIN 27,0,0,183 Q3 3.34.1 © 2004-2016 Apia, All rights reserved. © 2013 Cengage Learning except as noted. All rights reserved Grade It Now Save & Continue

Explanation / Answer

The answer to first question is "Relative purchasing power parity". It is an economic theory where the purchasing power parity is defined between inflation and exhange rate. Whereas for Absolute urchasing power parity, it only considers the exhange rate and doesn't account inflation rate.

The current forward rate is determined by the following equation assumong $ as base currency

Forward Exchange Rate (Euro) = Spot (Euro) *(1+ IR[euro])/(1+IR[$])

Euro = 0.8008*(1.026)/(1.013) = 0.8111

The $1 will cost Euro 0.8111 one year from now.

Decline in future spot value by (0.8111 - 0.8008)/0.8008 = 1.29%

Relative purchasing power is stronger with countries that have HIGH inflation rate.

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