The inflation rates in the British Pound and the Australian Dollar are 2% and 8%

Question

The inflation rates in the British Pound and the Australian Dollar are 2% and 8% respectively. What should the Sex /Forward Exchange Rate be, if the Spot Exchange Rate is BP/ .1 AU$? Describe the concept of purchasing power.

I know that this question has been solved before by Chegg, but everyone who has solved it has given a different answer making it difficult for me to figure out which answer is correct. Please solve this problem for me show your work step by step so I can understand what I am doing wrong and how I can approach this problem next time. Thanks in advance.

Explanation / Answer

<div class="ad-textlink full-width-iframe" "="">

What is 'Purchasing Power' : Purchasing power is the value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing power is important because, all else being equal, inflation decreases the amount of goods or services you would be able to purchase.

Note: As the spot exchange rate is not clear in the question it is assumed that spot rate is 0.57 British pound/Aus$

In the question Pound is the home currency and Aus $ is the foreign currency.

As per purchasing power parity theorem,Theoritical forward exchange rate is Spot rate(1+inflation rate in home currency)/1+inflation rate in foreign currency.

fwd rate = 0.57(1+2/100)/(1+8/100) = 0.538333.

As the spot exchange rate and theoritical forward rate are different there exists arbitrage oppurtunity.

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.