Suppose that the exchange rate adjusts so that interest-rate parity holds. suppo

Question

Suppose that the exchange rate adjusts so that interest-rate parity holds. suppose also that the interest rate on a one-year German bond is 7% and the interest rate on a one-year U.S. bond is 4%.

A. Suppose that you expected the exchange rate in one year to be 1.2 dollars per euro. What is the exchange rate today?

B. Suppose that relative purchasing power parity holds and that the inflation rate in Germany is expected to be 2% over the next year.
What is the expected inflation rate in the United States?

Explanation / Answer

A)(ig-ius)/(1+ius) = (F-E)/E (7%-4%)/1.04 = 1.2/E -1 1.028846154 =1.2/E E =1.166 the exchange rate today=$1.166 per Euro B) If real interest rates are equal, then ig-ius= pja-pus= (F-E)/E 2% -pus =0.028846154 pus = -0.88% expected inflation rate in the United States=-0.88%

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