These questions refer to Purchasing Power Parity. According to Interest Rate Par

Question

These questions refer to Purchasing Power Parity.

According to Interest Rate Parity, how would the dollar respond (appreciate, depreciate, no change) against the Euro in reaction to an average European inflation rate of 2%? The US inflation rate is 4% in this example—the term in question is 1 year.

Consider the relationship between expansionary monetary policy. the value of the dollar, and net imports.

How does this new dollar value impact net exports?

Do these two work with each other in regards to economic growth? Explain.

Suppose the current exchange rate is $1 buys .8474Euro, and key interest rates in the US are at 1% while they are at 3.5% in Europe.

1. If my stock in the European stock market rises by 20%, what movement would need to occur to cause me to lose money on my transaction (when accounted for in dollars—the term in question is 1 year)?

If the US Federal Reserve raises interest rates, how would you expect the Euro to move (appreciate or depreciate)?

Explanation / Answer

If the US inflation rate is 4% and Euro inflation rate is 2%, the dollar would depreciate as people in US would now imort more from Europe as it is cheaper. Also people in europe stop importing from US due to higher prices. Hence dollar depreciates.

If there is expansionary monetary policy, interest rates fall so, foreign investors pull out their funds from the country and invest in countries which provides higher interest rates. So, the value of the currency falls. As currency depreciates, it boosts the net exports as our goods become cheaper for foreign customers. So, this increases national income. Hence these two work together to increase economic growth.

If european stock market increases by 20%, more people from USA would want to invest in European stock market to capitalize on the gains. This would lead to depreciation of dollar. If there is enough depreciation, all the gains in european stock market could be wiped out.

If US interest rates increase, the euro would depreciate as investors from europe would start investing in the U.S as US provides a higher interest rate. So demand for dollar increases raising price of dollar which leads to depreciation of euro.

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