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 percent and the interest rate on a one-year U.S. bond is 4 percent. 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 percent over the next year. What is the expected inflation rate in the Unites States?

Explanation / Answer

interest rate on a one year German bond = 7% interest rate on a one year U.S. Bond = 4% future $/euro= 1.2 Exchange rate today be X (1.04/1.07 )X = 1.2 X= 1.2346 exchange rate today= 1.2346 dollars pers euro Inflation rate of us be X 1.2346x(1+x)/1.02 = 1.2 X= -.8585%

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