uestion 27 (Bonus 2): According to the Relative Purchasing Power Parity Conditio

Question

uestion 27 (Bonus 2): According to the Relative Purchasing Power Parity Condition (RPpp): If the inf lation rate between time-0 and time-1 is 5% in Great Britain and 2% in the US, the pound should... a) depreciate by 3.77% relative to the USD b) appreciate by 3.77% relative to the USD c) depreciate by 2.86% relative to the USD d) appreciate by 2.86% relative to the USD Use the following information to answer Ouestions 28 and 9:Kosom": 1.21 ; reso = 3%; rruR = 996; E(XusD/EUR)-1.19 Question 28 (Bonus 3): Which of the following two statements is correct? Statement A: According to the UIRP the short-run intrinsic value of the EUR is 1.12 Statement B: According to the UIRP the USD is currently overvalued relative to the EUR a) Statement A is correct b) Statement B is correct c) Both statements are correct d) Both statements are wrong

Explanation / Answer

27) Relative purchasing power parity states that:

S1 / S0 = (1 + Iy) ÷ (1 + Ix)

Where,
S0 is the spot exchange rate at the beginning of the time period (measured as the "y" country price of one unit of currency x)
S1 is the spot exchange rate at the end of the time period.
Iy is the expected annualized inflation rate for country y, which is considered to be the foreign country.
Ix is the expected annualized inflation rate for country x, which is considered to be the domestic country.

If we consider USD as foreign currency:

S1 / S0 = (1*0.02)/(1+0.05) = 1.02/1.05 = 0.971

so, pound has depreciated

depreciation % = (S0 -S1 )/ S0 = 1- S1/S0 = 1-0.971 = 0.029 = 2.9%

(c) is correct option

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