Question

Assume the the U.S. dollar and the Canadian dollar are initially in equilibrium. However the inflation rate in the U.S. is 2.5% and the inflation rate in Canada is 1%. The theory of purchasing power parity suggests which of the following is true?

	1.	We expect the USD to appreciate 1.5% relative to the CAD
	2.	We expect the USD to deppreciate 1.5% relative to the CAD
	3.	We expect the USD to appreciate 1.46% relative to the CAD
	4.	We expect the USD to deppreciate 1.46% relative to the CAD

Answer 1

According to the purchasing power parity theory, if the inflation rate of one country is greater than the inflation rate in another country, then the currency of the country in which the inflation rate is higher will depreciate in the future time period. In the given case, the inflation rate in US is higher than the inflation rate in Canada, which implies that the USD will depreciate relative to the CAD and the same is computed as shown below:

= [ (1 + inflation rate in Canada) / (1 + inflation rate in US) ] - 1

= [ ( 1 + 0.01) / (1 + 0.025) ] - 1

= - 1.46% Approximately

So, the USD will depreciate relative to the CAD by 1.46%

So, the correct answer is option 4 i.e. We expect the USD to depreciate 1.46% relative to the CAD

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