Question

Suppose the current spot rate is $ 1.55/£ on the first of January. By year's end, the US CPI is expected to climb from 144 to 150 and the UK CPI is expected to climb from 120 to 130. According to PPP, what is the expected spot rate on December 31? (Show your calculations!)

Answer 1

The expected spot rate is = $1.52

Step-by-step explanation:

The expected spot rate can be calculated using the purchasing power parity theory which helps in calculating expected rate of exchange by edjusting the spot rate of exchange to reflect the differential in interest rates between the two countries. In this question Foreign spot is pound sterling and local spot rate is US dollars.

Lets assume, foreign and local interest rates are 10% & 12% respectively. The formula of purchasing power parity is given below.

Expected spot rate=Current spot rate× (1+foreign spot rate) ÷ (1+local spot rate)

We may concise it using the initials as follows;

ESR=CSR× (1+foreign spot rate) ÷ (1+local spot rate)

ESR= $1.55× (1.10) ÷ (1.12)

The expected spot rate is = $1.52

Answer 2

= $1.4904/Pound

Step-by-step explanation:

As per Purchasing Power Parity, the price of a commodity in two countries is the same

Spot Rate = $1.55/Pound

% Inflation in US = (150-144)/144 = 4.1667%

% inflation rate in UK = (130-120)/120 = 8.3333%

Expected Spot Rate on Dec 31 = Spot Rate(1+Inflation Rate Dollar)/(1+Inflation Rate Pound)

= 1.55(1+4.1667%)/(1+8.3333%)

= $1.4904/Pound