Question

7. Assume you believe the relationship between the U.S. dollar and British pound is driven by relative inflation rates and income levels. You also use the following equation to forecast the pound on a quarterly basis: %/1.GBP: Ea+ P INF-1+ P INC 1-1 + Ett, where % GBP is che percent change in the direct exchange rate of the pound in quarter 1, INF is the inflation rate differential, and INC is the income level growth rate differential, both in quarter 1-1. You estimate the following coefficients: a=0.02, Pt= 0.8, and P2 =0.6. If the pound spot rate is $1.20 and the most recent quarterly data are that INF-1.5% and INC=0.7%, what would your forecast be for the pound spot rate this quarter?

Answer 1

direct exchange rate means price of 1 pound is expressed in dollars

Using the regression equation we see=0.02+0.8*1.5%+0.6*0.7%=3.6200%

Spot rate for this quarter=1.20*(1+3.6200%)=1.24344 dollars