For each of the separate cases below, use the information in that case to compute the expected depreciation of the dollar , or state if there is not enough information. State the name of the parity condition(s) you use and show your work.
Answers
Here, the inflation rate in US is1% while its-1% in Europe. So, the net difference is = 2%. So, the US dollar is expected to depreciate by 2%.
Real Interest rate (RRI) = Nominal interest rate (NRI) – inflation rate (dP)
For USA, RRIUSA = 3% - 1% = 2%
For Europe, RRIEU = 2% - (-1%) = 3%
So, Europe is a better place to invest given that return is higher there. So, the value of the Euro will appreciate and the value of the dollar will depreciate. If we assume free capital mobility,
The extent of the dollar depreciation can be calculated using the uncovered interest parity theory. Let d = expected depreciation of the dollar.
Then, according to UIP, RRIUSA = RRIEU + d
So, d = 2% - 3% = -1%
So, the dollar’sexpected deprication is1%.
(1+ RRIUSA) = (F/S) * (1 + RRIEU), where F =forward exchange rate and S = Spot exchange rate
Using the information given, we get,
(1+ RRIUSA) = (1+2) = 3
(F/S) * (1 + RRIEU) = (1.11/1) * (1+3) = 4.44
So, (1+ RRIUSA) < (F/S) * (1 + RRIEU)
The expected depreciation of dollar = F –S = (1.1 -1)/1 * 100 = 10%
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