Question

Suppose that the price of the same basket of goods at time 0 is PC0= 100 in country C and PD0= 90 in country D, so that the exchange rate is SCD0=10090. Inflation rates are expected to be 10% in country C and 21% in country D, over the foreseeable future.  

a) Does PP approximately predict an appreciation or depreciation of currency C?

b) What are the expected price levels in the two countries (i.e., PC1 and PD1 ) andthe expected no-arbitrage exchange rate in one period (i.e., SC1 )? (Use the exact
form).

c) Use answer b) to check that your answer a) is correct.

d) What is the expected no-arbitrage exchange rate two-years into the future?

Answer 1

Answer

a) Calculation of PPP

PPP = Price in Country C / Price of Country D

= 100 / 90

= 1.10

So the currency C is depreciating.

b)

Calculation of expected price level in both countries
	Country C	Country D
Price at 0	100	90
Price at 1	110	108.9
Currency Ratio at 0	1.11
Currency Ratio at 1	1.01
Reduce ratio 0 from Ratio 1	0.10
Divide Ratio by highest	9%
So currency C will be depreciated by 9% against currency D

c) Yes