Question

The interest rate on South Korean government securities with one-year maturity is 4% and the expected inflation rate for the coming year is 2%. The U.S. interest rate on government securities with one-year maturity is 7% and the expected rate of inflation is 5%. The current spot exchange rate for Korea Won is $1 = W1,200.

Forecast the spot exchange rate one year from today.

Explain the logic of your answer.

Answer 1

Real Interest Rate in South Korea = Interest rate - Inflation Rate = 4%-2% = 2%

Real Interest Rate in US = Interest rate - Inflation Rate = 7%-5% = 2%

Since real interest rate is same in both countries, the spot exchange rate will change only because of inflation

$1 will inflate by 5% in US i.e $1 value will be = 1*(1+5%) = 1+5% = 1+0.05 = $1.05

W1200 will inflate by 2% in South Korea i.e W1200 value will be = 1200*(1+2%) = 1200+1200*2% = 1200+24 = W1224

Hence the New Spot Exchange Rate will be $1.05= W1224

or, $1= W1224/1.05

or, $1 = W1165.71