Question

if country A has inflation of 5% p.a . and country B has inflation of 10%p.a . and currently the exchange rate between countries A and B is 1A=2B, what will be the expected exchange rate after one year. show workigs.

Answer 1

Based on the application of Purchasing Power Parity, currencies with higher (lower) expected inflation will be excpected to depreciate (appreciate) in the future. Mathematically,

Inflation Differential = 10% - 5% = 5%

Currency for country B is expected to depreciate by 5% relative to that of Currency A.

Currently 1 A = 2 B,

5% depreciation in B would lead to

1 A = 2 * (1 + 5%) B

=> 1 A = 2.1 B (basically, since inflation is higher at B, B's currency would depreciate. Earleir for every 1 unit of A you received 2 units of B. Now for every 1 unit of A you will receive 2 .1 units of B)

{Exact calculation can also be done using the formula 2 * (1 + 10%)/(1 + 5%) = 2.095. 1A = 2.095 B will be the exchange rate next year)