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 expect 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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