Author Question: Describe and explain the relationship between expected inflation rates in two countries and their ... (Read 21 times)

fnuegbu · **on:** Jun 30, 2018

Describe and explain the relationship between expected inflation rates in two countries and their interest rate differential according to the PPP theory.

What will be an ideal response?

Question 2

What is the expected dollar rate of return on dollar deposits if today's exchange rate is 1.10 per euro, next year's expected exchange rate is 1.165 per euro, the dollar interest rate is 10, and the euro interest rate is 5?

A) 10
B) 11
C) -1
D) 0
E) 15

kxciann · **Reply #1 on:** Jun 30, 2018

Answer to Question 1

Expected inflation is given by the following equation:
e = (Pe - P)/P where Pe is the expected price level in a country a year from today.
If relative PPP is expected to hold then:
( - )/ -
Combine the expected version of relative PPP with the interest parity condition:
R = + ( - )/
Rearrange:
R - = -
If, as PPP predicts, currency depreciation is expected to offset international inflation difference, the interest rate difference must equal the expected inflation difference.

Answer to Question 2

A