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Inflation is expected to be 2% per year in the USA and 1% per year in...

  1. Inflation is expected to be 2% per year in the USA and 1% per year in Japan. a) If the current FX rate is 120¥/$, what will be the FX rate in one year according to RPPP? b) If the price of a Big Mac in USA is $4.25 and the price in Japan is 500¥, how much is the yen overvalued against the APPP FX rate?
  2. In the above example if the price of a Big Mac in USA is $4.25 and the price in Japan is 500¥, how much is the yen overvalued against the APPP FX rate?
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Answer #1

US Inflation rate = 2% | Japan Inflation rate = 1%

Current FX rate = 120 Yen per USD

a) Relative Purchasing Power Parity

FX rate in one year = Spot rate * (1 + Japan Inflation rate) / (1 + US Inflation rate)

FX rate in one year = 120 * (1 + 1%) / (1 + 2%)

FX rate in one year = 118.82 Yen per USD

b) Absolute Purchasing Power parity

Purchasing Power Parity = Cost of goods in Yen / Cost of goods in USD

Purchasing Power Parity = 500 Yen / 4.25 USD = 117.65 Yen per USD

Current FX rate = 120 Yen per USD

As Current Exchange rate is 120 Yen per USD and APPP FX rate is 117.65 Yen per USD, that means, Yen is undervalued.

Percentage Undervaluation = (Current FX rate - APPP FX rate) / APPP FX Rate

Percentage Undervaluation = (120 - 117.65) / 117.65 = 2%

Yen is undervalued by 2%

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