Question

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Exercises: Parity conditions in real markets and financial markets EXERCISE 8 (Fisher effect & Purchasing Power Parity) If expected inflation is 100 percent in Venezuela and the real required return is 5 percent. a) What will the nominal interest rate be according to the Fisher effect? b) What can we expect to happen with the exchange rate of $/Bolivar, taking the different inflation rates into consideration, assuming that USA inflation is 4%?

Answer 1

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(It nominal interest rate) = (1+real interest rate) CI+ inflation gate) lit nominal interest rate) = (1+0.15) (+1) It nominal interest rate = 2.3 nominal interest hate = 2.3-1 I nominal interest rate = 1.3 or 130% inflation Inflation in Venezuela = in USA = 100% 4% or or I 0.04 assumption We con solve the problem by taking an let the spot rate of $/ Bolivar be 1 lie. Bolivar 1 = $1 Now using Purchasing Power forward rate ($ / Bolivar . - spot rate / Bolivar) Varity & inflation It It Bolivar inflation = forward rate ($ / Bolivar) = 1+0.04 1+ 1 forward rate ($ / Bolivar) = 1.04XL forward rate & / Bolivars = 0.52 ie forward rate = $0.52 per Bolivar Co. We can conclude that enchange rate will decline & will appreciate against Dolwar. ico