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PPP predictions of exchange rates: Review PPP theory and the Law of One Price as they...

PPP predictions of exchange rates: Review PPP theory and the Law of One Price as they relate to expectations about currency exchange rates. Suppose two countries, Britain and the US produce just one good: beef. Suppose that the price of beef in the US is $2.80 per pound, and in Britain it is £3.70 per pound.

(a) According to PPP theory, what should the $/£ spot exchange rate be? (b) Suppose the price of beef is expected to rise to $3.10 in the US, and to £4.65in Britain. What should be the one year forward $/£ exchange rate? (c) Given your answers to parts (a) and (b), and given that the current interest rate in the US is 10 percent, what would you expect current interest rate to be in Britain?

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