| DEG,Annual Foreign E(SJ- Expected Exchange | huse. Annudal Inflation Rate Spot

Question

| DEG,Annual Foreign E(SJ- Expected Exchange | huse. Annudal Inflation Rate Spot Rate in t Years in Rate in the United So= Current Spot Rate Country Inflation Rate in European Terms (Foreign currency per European Terms (Foreign States US dollar)currency per US dollar) 1 USD 0.8502 EURO Using the data above and textbook equation (18.3) E(S.)-So1 (hc- hus)l' and assuming the estimated inflation rate in Year 1 also holds for Years 2 and 3, please respond to the following: a) Based on relative purchasing power parity, estimate S, b) Based on relative purchasing power parity, estimate S2 a e

Explanation / Answer

So = current spot rate E(St) = Expected Exchange Rate Spo Rate in t years in European Terms hUS = Annual Inflation in USA hFC = Annual Foreign Country Inflation 1 USD = 0.8502 EURO 2.00% 1.50% Using equation E(St) = S0*(1+(hFC - h US)]t For S1 = E(S1) = S0 * (1+(hFC - hUS)] For S1 = E(S1) = 0.8502* (1+(0.015 - 0.02)] 0.845949 For S2 = E(S2) = S0 * (1+(hFC - hUS)]2 For S2 = E(S2) = 0.8502* [1+(0.015 - 0.02)]^2 0.841719255

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